Stocks are More Volatile But Have the Potential for Higher Returns

Stocks or bonds? And how much of each. BueroMonaco/Taxi/GettyImages

When you build a portfolio, one of the first steps you must take is to determine how much of your money you want to invest in stocks vs. bonds. The right answer to this depends on many things including your experience as an investor, your age, and the investment philosophy that you plan on using.

For most people, I think it helps to take the approach that investing is for life, and your time horizon is life expectancy. When you take this long-term approach you can use something called strategic asset allocation to build a portfolio model that you follow for many, many years.

This approach is based on historical measures of the rates of return and levels of volatility (short term ups and downs) of different asset classes. F or example, historically stocks have had a higher rate of return than bonds, but more volatility.

The four allocation samples below are based on a strategic approach — meaning you are looking at the outcome over a long time period (15+ years). Success is not based on measuring returns daily, weekly, monthly, or even yearly — but over multiple year time periods.

1. Ultra Aggressive Allocation: 100% Stocks

If your goal is to achieve returns of 9% or more, you’ll want to allocate 100% of your portfolio to stocks. You must expect that at some point you will experience a single calendar quarter where your portfolio is down as much as -30%, and perhaps even an entire calendar year where your portfolio is down as much as -60%. That means for every $10,000 invested, the value would drop to $4,000. Over the course of many, many years, historically the down years (which have occurred about 28% of the time) should be offset by the positive years (which have occurred about 72% of the time).

2. Moderately Aggressive Allocation: 80% Stocks, 20% Bonds

If you want to target a long-term rate of return of 8% or more, you’ll want to allocate 80% of your portfolio to stocks and 20% to cash and bonds. You must expect that at some point you will experience a single calendar quarter where your portfolio is down as much as -20%, and perhaps even an entire calendar year where your portfolio is down as much as -40%. That means for every $10,000 invested, the value would drop to $6,000. It is best to rebalance this type of allocation about once a year.

3. Moderate Growth Allocation: 60% Stocks, 40% Bonds

If you want to target a long-term rate of return of 7% or more, you’ll want to allocate 60% of your portfolio to stocks and 40% to cash and bonds. You must expect that at some point you will experience a single calendar quarter and an entire calendar year where your portfolio is down as much as -20% in value. That means for every $10,000 invested, the value would drop to $8,000. It is best to rebalance this type of allocation about once a year.

If you are more concerned with capital preservation than achieving higher returns. then invest no more than 50% of your portfolio in stocks. Investors who want to avoid risk need to stick with safe investments .

The allocations above provide a guideline for those who are not yet retired. The allocation models are based on attempting to maximize returns while not taking on too much volatility. These allocations may not be right for you when you shift to retirement where you will need to take regular withdrawals from your savings and investments.

As you shift to taking withdrawals your investment goal changes from maximizing returns to delivering reliable income for life. A portfolio constructed to maximize returns may not be so effective at generating reliable income for life. Remember, as your life phase and goals change, your portfolio needs to change.

If you are near retirement you’ll want to check out some alternative approaches. To learn more read: