NO QUESTION, MANAGING an investment portfolio is tricky. On the one hand, you want stock market exposure to help drive your portfolio’s performance. But on the other, it’s agonizing when the market drops 30% or 50%—or more—as it’s done on several occasions.
How can investors strike the right balance? Like most things in personal finance, there isn’t one right answer. In general, investors can choose one of five approaches when building a portfolio.
1. All stocks. This first option is, in many ways, the simplest. But it isn’t easy. Since the 1920s, the U.S. stock market has returned about 10% a year, on average. But it’s hardly been a straight line. That’s why I say this approach is simple but not easy and why, as a result, many see an all-stock portfolio as altogether too risky. There are, however, three situations in which the volatility of a 100% stock portfolio might be tolerable and thus this approach might make sense.
First, if you’re in your working years and regularly adding to your savings, you might go with 100% stocks in your retirement accounts. I would certainly recommend, almost universally, 100% stocks for Roth and health savings accounts, which benefit from tax-free growth.
Another situation in which I’d recommend an all-stock portfolio: if you have young children and you’re investing their 529 accounts for college. I generally recommend lightening up on stocks in 529s only when children reach middle school.
Finally, there are folks who enter retirement with enough income from outside sources that they can afford to take any amount of risk with their portfolios. If some combination of a pension, Social Security and passive income allows you to meet your monthly expenses, you could invest your portfolio for maximum growth, even if that also means maximum risk.
2. Tactical. Some years ago, I recall speaking with an executive at a large Wall Street bank. He regularly attended the bank’s investment committee meetings. But his reaction surprised me: “I leave these meetings not knowing any more than when I went in.” The problem was that the bank’s investment recommendations, like much of the advice that comes out of Wall Street, was tactical—that is, short-term in nature based on economic forecasts. This is an approach to investing that’s notoriously difficult.
Consider just the most recent example: In 2020, when the pandemic emerged, investment prognosticators were correct in predicting a market downturn. The market did indeed drop—by more than 30%. The problem, though, is that it didn’t stay down for long. Stocks rebounded quickly, resulting in a positive return overall for 2020. In fact, 2020 turned out to be an above-average year, with the S&P gaining 18.4%, including dividends. The following year, the S&P gained another 29%. There may be someone out there who had perfect timing—selling before the market dropped and then buying back in after stocks fell—but it would have been extraordinarily difficult. No one can see around corners.
Research by Morningstar confirms how difficult this is. Among professional money managers, those who pursue tactical strategies have fared particularly poorly. These types of funds, in Morningstar’s words, have “incinerated” investment returns. As a group, they’d have delivered returns that were twice the funds’ actual returns if their managers hadn’t traded at all over the past 10 years—if they’d simply gone on vacation.
3. Asset allocation. Tactical traders’ results illustrate why, in my opinion, investors shouldn’t make predictions. Instead, I recommend the portfolio management prescription offered by investor and author Howard Marks: “You can’t predict. You can prepare.” While market forecasting makes for entertaining cocktail party conversation, it’s too unreliable. Instead, what investors should do is to prepare, so their portfolios could withstand a market downturn at any time. That’s critical because bear markets don’t tend to give much notice.
How can you prepare your portfolio? The key is to choose an asset allocation that won’t require you to sell any of your stock market holdings even if the market dropped 50% or more and stayed down for a multi-year period. For example, if you’re retired and require $100,000 per year from your portfolio, you might hold $500,000 to $700,000 in a mix of cash and bonds, allowing you to ride out a downturn at any time.
Your chosen asset allocation need not be static forever. As your spending needs shift, you might add or subtract from this stockpile of safer assets. Importantly, though, you wouldn’t need to shift your portfolio in response to market events or market forecasts.
4. Judiciously opportunistic. Howard Marks often reiterates his mantra that “you can’t predict,” but he does allow for some exceptions. In his most recent memo, Marks noted that he has, in fact, made a few predictions over the years. How many? In 50 years, he says, he recalls five.
Marks explains his reasoning: “Once in a while—once or twice a decade, perhaps—markets go so high or so low that the argument for action is compelling and the probability of being right is high.” Only then is Marks willing to bet on a forecast. In late 2008, for example, when the Lehman Brothers collapse sparked a drop in both stock and bond prices, Marks started buying. Similarly, in March 2020, when the pandemic caused the market to drop more than 30% in the space of six weeks, Marks again loaded up on depressed shares, betting (correctly) that the downturn would be temporary.
Marks, I think, makes an important point. In general, it’s better to avoid predictions. But as with most things in personal finance, it’s also important to avoid being too dogmatic. Sometimes, it’s okay to take a step or two out on a limb. In 2020, for example, when the Fed began printing money at an extraordinary pace, there was a clear risk that inflation might pick up, and that this would force the Fed to raise interest rates. To guard against this, many investors shortened the durations of their bond portfolios. With rates near zero, this was a relatively safe bet.
5. “No” risk. Some investors are so wary of the stock market that they choose to hold all their savings in bonds. On the surface, this seems like a way to play it safe. Indeed, in modern portfolio theory, the U.S. Treasury bond is referred to as the “risk-free asset.”
But I refer to this strategy as “no” risk because it’s actually quite risky. The danger, of course, is inflation, which degrades the purchasing power of bonds. Even inflation-linked bonds aren’t a perfect inflation hedge. Last year, when inflation approached 9% at one point, Treasury Inflation-Protected Securities (TIPS), on average, lost money. For this reason, even though it may appear safe, I’d steer clear of an all-bond portfolio.