I’M 28 YEARS OLD. How much should I have in stocks? Some financial experts would suggest allocating 90% of my portfolio, because I have a long time horizon and a steady job. But I don’t think that would be a good idea for me.
My father has driven hundreds of thousands of kilometers over his lifetime—because he’s afraid of flying, despite the much lower risk that air travel entails. Similarly, I have a good idea of what optimal investing behavior looks like for someone of my age. But for me, the right asset allocation isn’t the most “efficient” one, but the one that will let me sleep at night.
So why aren’t I investing as aggressively as some might advise me? For starters, I think it’s important to distinguish facts from opinions. It’s a fact that, if we pay less in investment costs, we’ll keep more of whatever we earn. But it isn’t a fact that stocks will generate better returns than bonds in the coming decade. Rather, it’s an opinion. Our assumptions and beliefs can be—and sometimes are—wrong. What are the implications if our belief in the stock market’s superior performance turns out to be mistaken?
It’s a tradeoff we all make: if we’re conservative in our asset allocation, we benefit less from rising stocks, while suffering less when prices decline. Meanwhile, if we’re aggressive, we’ll reap larger benefits if stocks rise, but we could be severely harmed if the market loses value over the next decade.
It isn’t hard to identify the worst of those two scenarios. The second would obviously have a much bigger negative impact. I find it helpful to think about extremes, because I know I’d prefer avoiding a really bad outcome, even if it means smaller positive ones.
With COVID-19, we’ve seen things we never thought possible. What other events could happen that we haven’t contemplated? And is there a way for us to limit the impact on our wealth? Considering different scenarios may expose weaknesses in our finances. Perhaps we’re holding too little cash or our stock portfolio isn’t diversified enough.
As Morgan Housel recently said in a thoughtful conversation with bestselling author Annie Duke, “Investing is about surviving the widest number of outcomes.” If our goal is to ensure we’re okay financially, pretty much no matter what happens, what does that imply for our portfolio?
Suppose market crises happen about once every 10 years and that they can potentially cause stocks to lose half their value. If you’re 100% in stocks, your portfolio would be down 50%, while a 40% allocation to stocks would leave you down 20%—and that assumes no offsetting gains from other parts of your portfolio.
After going through this exercise, I realized I wouldn’t be comfortable investing more than 70% in stocks. This should limit the potential decline in my portfolio to around 35%. Anything more than that would be simply too painful for me.
Marc Bisbal Arias holds a bachelor’s degree in business and economics, and is a Level I candidate to become a Chartered Financial Analyst. He started his professional career at Morningstar, performing research and editorial tasks, and is currently employed by Dow Jones in Barcelona, Spain. Marc’s previous articles were Mind Over Money, The Upside of Down and Setting Boundaries. Follow him on Twitter @BAMarc.