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Post #12 – The Importance of Equity Allocation, Part II

In my last Post, “Post #11 – The Importance of Asset Allocation, Part I,” I make the point that the percentage equity allocation of your portfolio is the major determinant of its long term returns. I’m sure many of you are probably thinking “Great, next he’ll be telling us the world is round!” But my previous post is just a prerequisite to the more important discussion about equity allocation and managing risk in the post you are reading now. Frankly, this is one of the more important posts I will write.

The real challenge for every investor is to allocate the right percentage of assets to equities (stocks) and the right percentage to fixed-income investments (i.e., all bonds, money market accounts, CDs, or cash savings accounts). To assist you in your thinking, I have included the table from Post #11, but I have added 2 additional rows.

Return of Different Equity Allocations for 20 Years from 1990 to 2009

Equity Portion is S&P 500 Index Including Dividends

Fixed Income is 30% ST Treasuries & 70% Intermediate Treasuries

Portfolios “Re-balanced” Annually

How Much in Equities?

Of course everybody wants to get the highest returns possible. But, as everyone knows, there is no free lunch. Look at the bottom two rows in the above table. They represent, for each equity allocation percentage, the worst one calendar year return and the worst cumulative 3 calendar year returns from 1990 to 2009. For 100% equities, the average 20 year return was 10.1% but the worst one year return (which happened to be 2008) was -37%. And the worst 3 year return was -43.1% (which occurred in 2000-2002).

At the other end of the allocation table, 100% fixed income, the average annual return was only 5.9% but the worst one year return was only -4.4%; the worst cumulative 3 year return was a positive 6.0%. So the decision becomes one of weighing the average long term returns versus the level of volatility you can tolerate. There is one clear finding from this data, and that is, if you are at or near your savings goal, there is no need to take a lot of equity risk. However, most people are not at their retirement savings goal. So the question remains: How far up the equity allocation scale should you go?

I have read much material on this subject. Some authors suggest that people investing for retirement, even investors in their 20s, should stick with a 50% equity allocation and then reduce it to 40% or 30% once they get close to their retirement date. Others say that you should have much higher equity allocations–100% equity until about age 50, and then start reducing your equity allocation to, perhaps, 75% at age 65. The reason behind the higher recommended equity allocations is primarily due to the view that fixed income returns are too low and that life expectancies are getting longer. In my opinion both these recommended allocations are too extreme.

Risk Tolerance Should Drive your Equity Allocation

Most people in their 20s and 30s are not even thinking about retirement. They are busy trying to get through their day to day life with family and work obligations. They are not focused on their retirement assets, nor should they be. Younger people should be saving diligently and have a simple diversified portfolio.  In a later post, I will discuss how to easily adopt a diversified portfolio. But mostly those in their 20s and 30s should just ignore the markets. They are so far from retirement and their retirement accounts small enough, that these investors are less likely to panic if the market tanks and therefore less likely to sell equities at inopportune times. Most of the people I know in this age group did not even blink an eye at the market turmoil brought on by the recent financial crisis. And this was to their benefit. For this reason I think younger investors can have a higher equity allocation such as 70% to 80%. But this allocation should never be 100%. There is a very important reason for this to be covered in a future post.

People who are within 15 years of retirement should, of course, have a lower equity allocation.  In 2008, many investors had to learn the hard way that they had invested too heavily in equities. When the financial crisis hit its peak that year, many retail investors could not handle the steep equity losses and sold out at or near the market bottom. Because many investors reacted to the crisis in this manner, I’m convinced that most people over estimate their tolerance for equity risk. Although it may be true that fixed income returns are too low and that life expectancies are getting longer, I don’t think this should be the basis for how much you should invest in equity assets, especially when experiencing a long term bear market, as we are now. Most non-professional investors cannot handle their emotions when equity markets suffer large losses. Therefore, in my opinion, the role of fixed income investments in your portfolio are for portfolio stability first and income second.

Please review the last row in the above table. These figures are useful because they show the potential negative returns that an investor must be able to endure to achieve the long term average annual returns indicated in the table. Many investors only focus on the higher returns that they want or need. However, in real life, you will not achieve the higher returns if you don’t maintain the equity allocation it requires. And, you won’t stick with the required equity allocation, if you sell your equity holdings when normal market fluctuations push you outside of your comfort zone.

The purpose of this blog post is for people to recognize that our emotions may have more control over our investment decisions than we realize. It is best for the investor to recognize this fact in advance and then set his or her equity allocation accordingly. That way, investor discipline can be maintained when market volatility rears its ugly head.

In my next post I will provide some suggestions as to how you might decide on the appropriate asset allocation.

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