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One of the questions which has come up more than once in client conversations is: Since stocks are projected to make more money over the long run, why do I need to own something other than stocks in my portfolio when I’m so far away from retiring? The short answer is that investors will do better by diversifying, but there is more to it than that.
Here are some specific reasons on why I’d recommend to include safer assets such as bonds, CD’s and cash in your portfolio.
- Just like with spending, it’s important to have a good defense as well as good offense. If your portfolio gets cut in half, it will have to double just to get back to where it was. If your portfolio only goes down 20%, you only need to gain 25% to get back to where you started. While Wall Street and the investing public focus on high investment returns, the real way to compound your wealth is to be invested as long as possible and to avoid significant draw downs.
- Lower chance of pulling the rip cord at the wrong time. As the 2008-2009 Financial Crisis demonstrated, it is very difficult to remain calm and not panic in the face of rapidly declining markets. While the percentages might be the same with a big pile of money versus a small pile of money, the emotional toll is far greater the bigger your portfolio is. For example, I worked with a widow who had about $1.3 million in her and her deceased husband’s IRA accounts. When the subject of risk tolerance came up, I asked her if she could stomach having her portfolio go down 20%. Her response came without hesitation – “Absolutely not! If the portfolio went down 20% that would be $260,000 which is what my house is worth!” Compare that 20% loss in a $50,000 portfolio; while $10,000 is nothing to sneeze at, for most people losing that amount of money doesn’t cause severe emotional reactions like losing larger figures does.
- Gives you the opportunity to make risk free return by rebalancing. Buy low and sell high is the most basic, yet the most difficult rule of investing to follow. It is very difficult for most people to sell things that are doing well and to buy things that have gone down in price. Rebalancing is the regularly scheduled act of selling winners and buying losers and bringing your investments back on course with where you want them to be. Research has shown that rebalancing can add from between .2% to 1.2% in annual portfolio returns over the long run. This extra return can make a huge difference over 20-30 years but to get the best results with rebalancing you need to own some things that ‘zig’ and other things that ‘zag’.
- After a certain point, greater stock exposure doesn’t add much to returns. The research varies depending on what stocks are looked at and when the research was done, but as a general rule once you go over 80% stock holdings in your portfolio, the expected returns only go up slightly, but the swings in value of your portfolio become much greater. As mentioned in above, big swings in value are your enemy as they cause a lot of heartburn and if you act on them, a lot of heartache!
A final thought – when you’re still working and accumulating assets, the primary role of bonds/cash is to provide safety and stability, not income. While it’s no fun to have the ‘safe’ part of your portfolio earn very little, it’s still important to have that piece in place. On a similar note, rising effects can have devastating effects on bonds, so you’ll need to be careful with how you invest that portion of your money, but that’s a subject for another blog post.