For most people, the answer is a resounding No. However it is an intriguing question – how much of your savings should go in to stocks? Should it be 100%, 50%, 0%? All of these could be right, however it all depends on your personal circumstances.
The ease of buying stocks has unleashed a wave of new investors and traders in the markets. However just because investors have easy access to the stock market, should they put all their money in the market? What is the appropriate asset allocation for investors? How much risk should an investor take? You might hear of professionals talking about asset allocation, risk tolerance, investment horizon, etc. Let’s dig further in to these topics before coming up with a more refined answer.
What is asset allocation?
Your investment portfolio might be comprised of stocks, bonds, real estate (rental properties), cash, or other items like cryptocurrencies. Asset allocation is the process of determining how much of your portfolio should go to each category. Some factors used for determining the appropriate allocation include:
- Total Level of income
- Whether there are any dependents
- Time horizon.
- Lifestyle expectations in the future
- Personal risk tolerance
A detailed assessment of these factors will help you determine how much of your portfolio should be invested in stocks. Read on for more information!
The importance of an emergency fund
First and foremost, do you have an emergency cash fund? Most of us can handle one thing going wrong in our lives, but what if there are multiple things? You must have an emergency cash reserve that can cover your expenses at a minimum for 3 months, but ideally at least 6 months. It takes time to build it up and can appear to be a drag, but when something goes wrong, you’ll be happy that it’s there!
Busting some myths – Age is not the only criteria
A common myth is that younger investors can have a very high level of equity investments (say, 100%) as they will not retire for a long time. However this is very misleading. Savings are not just about what you will do when you are old and gray. Savings are also for cash needs in the course of your life. Younger adults are busy building up their lives and can have many big and important expenses coming up within the first 5 to 10 years of their working career – buying a car, buying a home, getting married, traveling the world, etc. For such a person, having a greater cash savings component is vital.
On the other hand, someone who is 50 years old, in great health, own a house with very little mortgage left, no major expenses on children remaining, and plans to work till they’re 65, would be paradoxically better off having a very high equity allocation. This person is unlikely to need a large chunk of cash any time soon (an emergency cash fund is considered mandatory though), so they’re better off letting their portfolio compound over the next 15 years. It’s a very very long time!
Deep dive in to your personal situation
My recommendation is to not just follow rules of thumb, but to really dig into your personal situation and analyze what your needs are. If you need a big amount of cash within the next 3 years, my recommendation would be to allocate most of that to a cash savings fund. The rest can then be branched out to other asset categories, depending on your risk tolerance. Let’s look at that factor next.
What is Risk?
We all intuitively understand what risk is – it’s the chance of something going wrong or being exposed to danger. But in the context of investing, what does it mean? For most people, it reflects the chance of losing money. However financial engineers and marketers have a different take on it.
What is risk in the financial context?
Is it market volatility, company risk, bankruptcy risk, or something else? The common reference to risk is price volatility (how much the stock price goes up or down). The more volatile a stock, the riskier it is deemed to be. Conversely, the less volatile a stock, the less risky it is deemed to be. Often, the volatility of the stock is compared against a reference market index to gauge whether the stock is more or less risky than the market.
However simply relying on the volatility is quite a foolish way (in my humble opinion) to determine whether a stock is risky or not. While the volatility does convey some information, it is hardly an accurate indicator of risk. In the above image, Stock B would considered more risky, but it has the same starting and ending value as Stock A. So really, is it more risky?
Risk really should reflect the chance of losing some or all of your money permanently. In that sense, real estate can be riskier than the equity market. And equities can be safer than the bond market! It’s all a matter of context.
The myth of High Risk-High Reward
Before we get in to a detailed discussion on risk for your portfolio, it is important to bust another myth: there is no such thing as high risk, high reward. If higher risk always equated to higher return, it’s not really high risk is it?
In theory, risk and return are very closely linked, but that’s just financial engineering theory. Naturally, one would expect a higher level of compensation for taking on a greater risk. But what about the odds of winning?
If you make a risky bet (say investing in your friend’s new start-up restaurant), the odds of losing your money are actually very high! Most new businesses do fail and if your friend’s business shuts down, you lose all your money. In this case, your high risk bet did not lead to a higher reward. The “high” part of the risk came true, but the “high” part of the return did not.
Conversely, the restaurant could have hit it big and you would have made a ton of money! But again, its important to consider the odds. As per CNBC, 60% of restaurants fail in their first year of operation and 80% are closed by their fifth anniversary. That gives your friend a 20% chance of just surviving, and an even slimmer chance of making it big!
So in reality, the high risk, high reward strategy really is a high risk, very low likelihood of any reward strategy. In other words, its just speculation!
Risk: Short-term and long-term
Investment horizons are often underestimated when assessing risk. As the famous Warren Buffet quote goes, in the short run, the market is a voting machine, and in the long run, its a weighing machine. As most of us know through our gradually expanding waistlines, weight only goes one way over time!
Consider the two images below. The first one shows how stock volatility (i.e. “risk”) materializes at the individual stock level when considering time horizons.
Now this one shows how market volatility looks over the course of time: a market correction might feel painful when you’re in one, but in the bigger scheme of things, it is inconsequential.
Other than a cash savings account, every investment carries some level of risk. We all know that markets can be volatile and so there is always the risk of your portfolio value fluctuating greatly over short periods of time. There is always a risk that your portfolio may not be worth what you expected it to be worth when you need to withdraw that cash.
Therefore time horizon becomes a very important factor in determining your asset allocation. Time heals all wounds and it heals many portfolios, so if you do not need the cash from your portfolio within 5 years, then you can likely have a greater skew towards equities or real estate. However if you need the portfolio to be liquid (i.e. easily convertible to cash) within 3 to 5 years, but also more dependable in value, then your skew towards bonds and cash should be significantly higher.
What is Diversification?
Diversification captures how many different types of assets your investment portfolio contains. The fewer the variety, the lower the diversification; and conversely, the higher the variety, the greater the diversification. Just as you don’t want to put all your proverbial eggs in one basket, you don’t want your investment portfolio to contain just one (or just a few) different holdings.
The greater the diversification, the lower the risk of failure of one type of investment asset. So if one company in your portfolio goes bankrupt, the bonds issued by that company would lose most of their value. If your entire portfolio consists of just that one company’s bonds, you’re in trouble. However if that bond is just 1% of your total portfolio value, you likely will not even notice it!
It is not that difficult to diversify your portfolio. As long as your portfolio has a healthy mix of mutual funds and/or ETFs that invest in both stocks and bonds across most sectors and geographies, you are likely already well diversified. Add in some real estate and perhaps a small amount of commodities, like gold, and you’re likely good to go!
If your portfolio however is composed directly of a handful of stocks or sector ETFs, you should strongly consider adding other assets in to the mix that have a low correlation with the existing holdings.
What is Correlation?
In simple terms, correlation is how different asset prices move in relation to each other. For example, two technology stocks would likely have a high degree of correlation as their prices would likely move in a similar fashion. However, a technology stock and real estate prices in Essex likely have low correlation as their prices would move relatively independent of each other. The power of diversification lies in being able to put together a portfolio of assets that have low correlation with each other. If one asset class in your portfolio is down, you can still rely on something else to be up, which helps to maintain the total value of your portfolio.
Tolerance and Personality
You may have a sufficient time frame for your investments on paper, but can you stick to the plan? The unfortunate truth is that many, many people invest for many years with no issues but completely fold under the pressure of a severe market crash. Many investors will not have seen a severe market crash in their adult life, meaning that when one does occur (and it will) feels unique, different from the others – different because there could be a World War 3, or an energy crisis. Of course, the market has seen it all before. But, seeing your $200,000 portfolio drop to $120,000 in a few days can send people into panic mode, which they respond to often with a panic selling (please don’t!) to avoid further losses.
This is made worse because the news only focuses on the negative, and extreme, exaggerated headlines which gets clicks. Many people cannot resist this, letting it shape their worldview. So, investing a significant amount of your money into stocks is not for the faint-hearted.
Furthermore, checking your portfolio every day, along with the news, isn’t a good idea. You don’t need to know today’s market performance, you’re in it for years, so the more activity you have around reading and checking, the more likely you’re going to have high activity in regards to trading. And, this is meant to be a passive investment. Limiting yourself to adjusting your portfolio once a year is enough.
Should I put ALL of my savings in the stock market?
Should I invest my money in stocks? Probably. Should I put every penny I have into stocks? No, you shouldn’t. There are two main reasons for this: diversification and the need for an emergency fund.
As we concluded, investing in the market average returns requires a long-term plan – no money should be invested if there’s even a slim chance that you will need to sell it in an emergency. This is what an emergency fund is for, a buffer, so you needn’t liquidate your investments in the event you lose your job or fall ill. On top of this, there should be some “working capital” – just enough in your current account so you needn’t dip into the emergency fund should your wages come through late or when purchasing a holiday.
Secondly, there is a question regarding how well diversified your portfolio is when investing 100% into stocks. On the one hand, diversification across markets, countries, and large/small cap firms (assuming you have a global fund, not the S&P 500) couldn’t get any better. However, they’re still all equities, which means a stock crash is a systemic risk – highlighting you’re not as diversified as you could be. Whilst many argue it’s not absolutely necessary, adding real estate, commodities, currency, and bonds into your portfolio could provide a more hedged and balanced portfolio.
The final aspect to consider when determining your asset allocation is what is your personal knowledge of finance, economics, and the investing world; along with the amount of time you have to commit to researching the various opportunities.
In order to help you think about what you should invest in, the following framework may be of use:
- Low knowledge or lack of time: You need a low hassle approach in which someone takes care of all the investment work for you. Consider going to an advisor for a managed portfolio, signing up with a robo-advisor, or investing in broad market ETFs directly.
- A good amount of time and good knowledge of economics and finance: A combination of market and sector ETFs.
- High level of knowledge and lots of time: Stocks directly, but supplemented with some broad market ETFs to help maintain diversification.
Asset Allocation Calculator
I am working on developing an asset allocation calculator, however could use your help in gauging the demand for one. If you feel it would be of use to you, please send me an email or a message on Twitter. Please include any specific feature requests that you may have! Thanks very much!
What is a stock?
A stock or a share is a legal claim to the ownership of the equity of the underlying company. The holder of the stock (or share) has a claim to the underlying equity of the company and its earnings stream. The management of the company reports to the Board of Directors, which in turn is directly accountable to the shareholders of the company. These shares and stocks can be freely traded on the stock exchanges, allowing you – the investor – to move in and out of owning various companies faster than you can change TV channels!
What is the S&P 500
The S&P 500, which stands for Standard and Poor’s, is a basket that tracks the performance of the largest 500 companies that are listed on the US stock exchanges – tech firms, banks, real estate firms, big pharma – the lot. So, it’s not really an exchange itself (where you come to buy ownership in a company), but rather a mirror of the company’s values in real-time.
The good news is that you can invest in index funds (also known as Exchange-traded Funds, or ETFs), like ones that track the S&P 500, which means you can have a shared/pooled ownership of these 500 companies. The fund manager will sort out the legal stuff and execute the trades for you (for a fee) and you sit back, investing in just one fund, knowing your investments are split across all the biggest companies. So when looking at how to buy stocks – you may not need to do any direct buying in stocks.
|Alphabet Inc. Class A||2.0%|
|Alphabet Inc. Class C||1.85%|
|Berkshire Hathaway Inc. Class B||1.69%|
|Johnson & Johnson||1.41%|
|UnitedHealth Group Inc.||1.38%|
|Meta Platforms Inc. Class A||1.35%|
What is the long-term average return for S&P 500?
The average return of the S&P 500 since the mid-1950s to March 31st, 2022 is around 9.0% in USD (or 11.5% in GBP terms) , which is remarkable. In fact, it’s such a solid index that it has become the main benchmark that other investments are compared to.
How many negative years have there been for S&P 500?
From the 94 years leading up to 2021, the S&P 500 has had positive calendar year returns 68% of the time. So, only 1 in every 4 years we saw a negative year, on average. Interestingly, the percentage of up and down days has historically been very close to 50/50, but over time has grown closer to up days accounting for 57% of total trading days.
In 1931 during the Great Depression, there were 4 years of negative returns, with one year being -47.07%. In 2008, there were 5 consecutive years of growth leading up to it, which then saw a -38.49% drop, followed by a strong rebound until 2015.
What is the S&P/TSX Composite Index?
The S&P/TSX Composite Index is the index of the major stocks listed on the Toronto Stock Exchange in Toronto, Canada. The index is maintained by Standard & Poor’s. It is the headline index for the Canadian equity market and is the broadest in the S&P/TSX family. The benchmark reflects the heavy bias of the Canadian economy to resources, energy, and financial stocks.
|Royal Bank of Canada||6.15%|
|Bank of Nova Scotia||3.40%|
|Canadian Natural Resoruces Ltd||3.28%|
|Brookfield Asset Management Inc.||3.10%|
|Bank of Montreal||3.01%|
|Canadian National Railway||2.89%|
|Canadian Pacific Railway||2.79%|