For several years I served as an adjunct professor, teaching college courses in economics, finance and investment principles. So, for old time’s sake, I feel like starting this blog off with a multiple-choice question (you won’t be graded, so please don’t turn it in, although I do expect 100% student participation for the rest of this blog).

Q:  What is the most important decision every investor must make:‍

a. Forecast the change in U.S. GDP for the upcoming year.

b. Find the next Apple, Microsoft, Amazon or NVIDIA stock.

c. How much of your investable net worth to put in crypto currencies.

d. Devise a “black box” statistical model that calculates exactly when to get into (and out of) the stock market.

e. Decide the appropriate allocation of funds among risky assets (stocks and bonds) and cash.

f. None of the above

If you chose answer “e”, you get a gold star!  

Of all the decisions an investor can make regarding where to deploy investable funds, how much to allocate to stocks, bonds and cash is by far the most important.  In other words, how will your investment portfolio initially be structured?

But wait, I see a hand raised in the back row: “Shouldn’t maximizing investment returns be the overarching goal of any investment undertaking?”  Good question.  After all, investing in stocks has been the primary driver of wealth creation for decades. The S&P 500 Index (to pick one popular measure of the U.S. stock market) has produced an annualized rate of return of 11.5% per year over the past 80 years. By contrast, long-term U.S. government bonds and one-month U.S. treasury bills produced annualized returns of just 5.3% and 3.7%, respectively, over the same period [1]. So, why not 100% stocks?

That historical 11.5% average return on stocks was not obtained in a theoretical vacuum. Any investment in the stock market involves taking risk, especially the ever-present risk associated with changes in stock prices.  As shown below, annual returns on the S&P 500 are not achieved in a linear fashion, returning 11.5% per year like clockwork. They came with a great deal of volatility [2].

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Stock market volatility is even more pronounced when you consider intra-year drawdowns in stock prices, as shown below [3]. Since 1980, the average intra-year decline in the S&P 500 was -14.2%, even though stock returns were positive in 33 of those 44 calendar years and the index produced an annualized return of 9.0%:

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Investing 100% in stocks may be an acceptable risk for some investors, especially those with very long time horizons such as young people just starting out in their careers. But for many investors, having all of their investable assets in something as volatile as stocks is an unacceptable level of risk for a couple of reasons.  First, is their capacity for risk. If you are in retirement, for example, and you are drawing down your portfolio over time to fund part of your living expenses, you may be faced with withdrawing funds during a large drawdown in the market, the very worst time to sell stocks. The second consideration is your personal tolerance for volatility. Can you sleep soundly at night knowing your nest egg is 100% exposed to the volatility that inevitably comes with investing in stocks?

How do we mitigate the volatility risk of stocks, without completely shunning equities, an important source of wealth creation? This is where we introduce the benefits of bonds and cash.  Just remember that bonds are risky, too (cash has no volatility risk).  How risky are bonds? Compare this chart, which shows both annual and intra-year returns on the Bloomberg U.S. Aggregate Bond Index, with the stock version we looked at previously [4]:

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You will notice right away that the return variations are significantly less than that of equities.  Over the identical time period, stocks had eleven negative calendar years, while bonds had only five negative years (2022 was a doozy, though, producing a record annual decline for the index).  Average intra-year declines were also significantly lower, averaging -3.4%, as was the annualized total return of 6.6%.

Bonds also have another quality besides lower volatility which makes them an important building block in portfolio construction: they can often be an excellent diversifier.  A diversifying asset contributes a different return profile than other assets in the portfolio, which reduces the overall portfolio volatility. Bond prices tend to go up in times of significant downside volatility in the equity markets, partly because investment grade bonds can be a “safe haven” for investors when stocks are in decline.

We close this discussion by raising an important, but often overlooked, point:  long-term investors should not ask what portfolio gives them the highest return-for-risk, but rather how much risk do they need to take in their portfolio to produce expected returns that will meet their financial goals [5].  In other words, investors should seek an asset allocation that balances risk and return in such a way that the expected returns over time support their overall financial plan.  In most cases, that assumed return is less than the historical returns on a 100% equity portfolio, with much less volatility.

We apologize for the sensory overload in this last chart, but we think it illustrates this point very well [6]. The chart shows the annual returns from 2009-2023 for several sub-classes of investments (the colored boxes), with the best returning segments of the market at the top of each year’s column, and the lowest returning segments at the bottom.

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This chart makes a strong case for diversifying across segments of the market, as there is no predictable pattern to the returns. The white boxes represent the returns produced by a portfolio consisting of a blend of all the other market segments, 60% equities and 40% bonds.  It is immediately obvious that this 60/40 portfolio produces returns that are consistently “down the middle”, sandwiched between each year’s best and worst performing market segments. While it is not shown, the volatility of the 60/40 portfolio is significantly less than any of the individual segments (except cash).

One last chart reinforces the importance of asset allocation.  Here we see the historical average annual returns for six different allocation mixes of global stocks and bonds for the period from 1901-2022, from the lowest risk portfolio of 100% bonds to the highest risk portfolio of 100% stocks [7] :

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Successful long-term investors use this kind of market data to discern the proper asset allocation in their portfolios.  For some, a 60/40 stocks-to-bonds will be appropriate, while for others, it could be 30/70 or 80/20.  Every investor’s financial situation is unique, and our focus at Coyle Financial is helping you gain clarity on the allocation structure that is the right fit for you.

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^{[1] Matrix-Book 2023, Dimensional Fund Advisors}

^{[2] https://awealthofcommonsense.com/2024/01/historical-u-s-stock-market-returns-through-2023/}

^{[3] Guide to the Markets – US, 1Q2024, J.P.Morgan Asset Management}

^{[4] Guide to the Markets – US, 1Q2024, J.P.Morgan Asset Management}

^{[5] Inspired by the article “Why Not 100%Equities?”, by Cliff Asness, AQR Capital Management, LLC}

^{[6] Guide to the Markets – US, 1Q2024, J.P.Morgan Asset Management}

^{[7] Vanguard’s Principles for Investing Success,The Vanguard Group, Inc., 2023}