Outside the Box: Is your portfolio ready for bad times ahead?

This is very nice for investors. But when it looks easy to make money, it’s also easy to conveniently forget that the stock market is an unpredictable force that seems to want to punish overconfident investors.

Although you’ll get more endorphins from watching your investment balances grow, you’ll do yourself a lot more good if you set out to learn from the past, then prepare yourself and your portfolio for the rough patches that are surely ahead.

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The question: How much of your portfolio should be in bonds?

The short answer: That depends on what you want.

• If you want high long-term returns and don’t care about short-term and intermediate-term losses, then you can go full-steam-ahead with stocks.
• If your main concern is to avoid losses, you can keep most of your portfolio in bonds, knowing your long-term return will be significantly less.

For most people, the right balance is somewhere in between.

The following short table shows returns and a few risk factors from the past 51 calendar years, with stocks represented by the S&P 500 index and bonds represented by a combination of intermediate and short-term government bonds plus TIPS.

You’ll see the results for three quite different allocations: 20% equities for the very conservative investor, 50% equities for the moderate investor, and 100% equities for the aggressive investor.

To help you interpret those numbers, standard deviation is a measure of unpredictability, hence the comparative level of risk. The last two columns measure the worst losses: over any 12-month period and over a period of any length during these 51 years.

I have long believed that a moderate allocation of 50% in equities may be suitable for many cautious investors, including those who are retired. This is the approach I take with my own investments.

But fortunately, there are lots of choices. You’ll find other combinations, in 10% increments of equity exposure, in this table, which is particularly useful because it has 10 additional columns, showing year-by-year returns for stock-and-bond combinations in 10% increments.

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Over the years, this information has helped thousands of investors fine-tune their asset allocations.

The results of the worst periods, ranging from three to 60 months, offer a sense of what you’re likely to have to withstand in order to earn the expected long-term rates of return.

One thing I hope you’ll get from this large table is how random the returns can be. For example, in only nine of 50 years was the stock market’s return within 10 percentage points of the previous year.

There’s no way to know in advance when the market will be favorable and when it will be dismal. From 1995 through 1999, the S&P 500 compounded at 28.7%.

At the end of that period a survey of investors indicated their average expectation for the next 10 years was between 20% and 30%. But those optimistic investors were in for a rude awakening, as the first 10 years of this century included two brutal bear markets and a compound rate of return that was an annual loss of 1%.

At the bottom of the table you’ll see clearly that every additional increment of stocks brought a higher long-term return. I have argued before that a difference of only 0.5% in return can translate to an extra $1 million over a lifetime — so these increments really matter.

My regular readers know that I believe strongly in diversification beyond the S&P 500. In a recent article, I described a Worldwide Four-Fund Combo equity portfolio that’s built with equal parts of four asset classes: U.S. large-cap blend, U.S. small-cap value, international large-cap value, and international small-cap blend.

Table 1 showed the worst 12 months and worst drawdowns for portfolios based on the S&P 500. In Table 2, you’ll see the same figures for the Worldwide Four-Fund combo.

The risks look higher in Table 2 — so were the returns.

However, our focus here is on reducing risk rather than enhancing returns. Standard deviations make the Worldwide
Four-Fund Combo seem more risky than the S&P 500.

But what really matters about risk is whether or not it prompts investors to “jump ship” in stormy seas.

In the real world, investors don’t abandon their portfolios because of statistics. They jump ship when they are no longer willing to tolerate disappointing results.

Maybe you can tolerate a few years of losses. But an entire decade?

If we added a “worst 10 calendar years” column to those tables, we’d see something startling: a negative compound return (-1.4%) for the S&P 500 and a positive compound return (4.6%) for the Worldwide Four-Fund Combo.  

I think that could make a strong case for diversifying the equity part of any portfolio.

And that’s entirely in addition to the higher long-term returns from the diversified portfolio.

Over a period of 51 years, using the 100% equity allocation as an example, a one-time investment of $1,000 would have grown to $178,455 at the 10.7% compound rate in Table 1 vs. $354,516 at the 12.2% rate in Table 2.

That’s a huge extra return. And by the standard of the worst 10-year period, it came with much less risk.

There are plenty more lessons to be learned from 51 years of year-by-year results, and I discuss some of the most important ones in my latest podcast.

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Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways To Supercharge Your Retirement.