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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.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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I keep reading this, trying to understand what it means. It sounds like tactical strategies did well, delivering twice the return.
Just the opposite: If these funds had stuck with the initial investment mix, they’d have ended up with returns that were double that of what they actually earned. In other words, all their subsequent trading hurt results.
I know, but it’s a very convoluted sentence. What you wrote is much clearer.
I’ve only made one market prediction in my life, which I shared with friends to no avail: When the pandemic hit China, along with the accompanying scenes of lockdowns and business shutdown, I sold all equities and managed to repurchase them on sale at the bottom. I don’t pretend to be prescient about markets but this was one instance in which I felt that there was no reason to think this pandemic wasn’t coming to our shores. It worked out great. I didn’t think it was brilliance on my part. Just common sense. Opportunities like that are rare, I admit.
You’ve made two market predictions. How did you predict the bottom?
Thanks Adam. If we didn’t already know it’s unwise for most of us to be making big macro bets, the fact that someone like Howard Marks has felt confident enough to do so only five times in fifty years should be a strong indicator.
I used to think could I afford to lose 50% of my equity allocation at retirement and still live my lifestyle without panic. So I became very conservative and have lived off the income generated from my portfolio for at least 13-14years. I do believe as others stated the goal is not to die poor. My biggest worry is LTC. Funding our Roths for that need with partial Roth Conversions. Another worry is where taxes will be in 20226
Another thoughtful piece, Adam, thanks.
The approach I use is asset allocation, though early on, others would have said it was no risk. My guidance then and now is, “how much of a portfolio decline am I comfortable with?”.
Initially, the answer was “none” and I built a nest egg with aggressive saving and fixed income investments. Like Kenneth in the comments below, I benefited from higher interest rates. About a third of the way towards my goal, I felt secure enough to add stocks to the mix. As my base of fixed income grew, so did my risk tolerance.
Having met my goal and then some, now when I rebalance the answer is generally “25%”. Imagining a market drop of 50%, that leads to 50/50, stocks to bonds. I still sleep well at night and have the income I need with some potential for growth.
One more point: If you will barely have enough to cover retirement expenses with Social Security and savings, a TIPS ladder is not a bad option, especially now that real TIPS returns are much higher.
Rather than focus on a desired asset allocation, I use a simpler approach. My wife and I are 70, retired 5 years ago, and use a modified version of the “4% Rule”, using 3%. We keep enough in cash and short term treasuries/TIPS to fund 10-12 years worth of withdrawals, with the balance in stocks. This drives our allocation, which ranges between 70/30 and 65/35.
While I used to think of the 1929-1932 crisis as ancient history, I was born only 21 years afterwards. When we age, our perception of what constitutes “old or ancient” can evolve. Bernstein reminded me of a few subsequent multiyear periods of poor stock performance which have occurred in my lifetime. And his review of history makes it seem very likely we will experience bad markets again. He reminds us that our goal is, or at least ought to be, “not to get rich but avoid dying poor”. A 25 year cushion ought to provide protection from future bad markets, but I worry about inflation eroding it’s buying power. You and Jonathan suggest 5-7 years worth ought to be sufficient. I chose to compromise, and settled on 10-12 years. For now. I wonder where others stand on this?
Thanks for another excellent article Adam.
We have a 10-year TIPs ladder which is liability-matched against the gap between future income and all expenses but will also cover RMDs. Plus 2 years in cash/money markets and a 2-year rolling CD. That’s about 25%. Another 25% is a mix of bond ETFs, with 50% in stock ETFs/funds. The bond ETFs feed the TIPs ladder and rebalance the stock allocation. This comment in Adam’s article:”Last year, when inflation approached 9% at one point, Treasury Inflation-Protected Securities (TIPS), on average, lost money” should be balanced against this point in the linked piece: “For individual TIPS holders, any potential price declines might not matter if they’re held to maturity.”
I’m retired but my wife still works. We have 5 years in cash and short term treasurys and TIPS, another 5 years in intermediate term bonds and TIPS, and the rest in equities. All buckets are a mixture of individual bonds, stocks, mutual funds and ETFs. I’m also building a TIPS ladder (from auctions) for half of our spending in the period from when my wife plans to retire to when I start collecting Social Security at 70. Also thinking about a QLAC. With these and our small pensions we should not have to use much of our portfolio and will probably shift much more to equities once these all kick in.
We’re younger and new at the retirement gig so still learning, but we also keep ~12 years of draws in cash/MM + short Treasuries + TIPS and the rest in stock for a ~70/30 allocation. It may be more cushion than necessary, but we like it. We’re also keeping our average for annual draws at or below 3% as a margin for surprises and lower expected stock returns. With our split between tax deferred (IRA) and taxed savings, it enables a simple system for draws: use 4% then RMDs at 75 from the IRA and use only dividends from the taxed account.
I like your logic David. I do see a silver lining in holding more cushion than necessary. Not only does it make it easier to stay the course during a protracted bear market, it can also serve as a source of cash to buy additional stocks on sale, as described by Bernstein.
During a deep fire sale, when prices are plummeting and talking heads on the news are screaming fearful nonsense, it’s helpful to have a plan for your buys to stay the course. Some use DCA (steady time-based, fixed amount per purchase over a set period), or value averaging (more complex), or a set number of buys at target prices or risk premia. Others simply rebalance to allocation targets when the drop passes a certain percentage.
Without a plan your lizard brain takes over which freezes you in place or leads to leaping too soon, so you miss the bigger part of the opportunity. It’s impossible to know the bottom, but you can reap a good share of the discount to unlock better returns going forward.
Very Well said. 100% stocks with DCA when starting your career is very plausible. When I started out in the late 70’s-early 80’s interest rates on long term Treasuries were quite high; think the 30yr was at one time 15-16%. That being said anyone who went out 30yrs was very happy. I bought zero coupon bonds to fund 3 kids education with tax rates then at the Child’s rate