February 10, 2022
Written By: Andrew Hallam
I’m going to share a ghost story. Hopefully, it will be helpful. But before I do, I’ll provide some context.
For starters, investors with medium-risk portfolios comprising 70 percent stocks and 30 percent bonds could beat most investors that invest 100 percent in stocks. That might sound strange, considering that over full market cycles of 15 years or longer, portfolios allocated 100 percent to stocks usually do better.
But how an allocation performs, and how an investor performs with a given allocation are often two different things. For starters, new investors almost always overestimate their tolerance for risk. That’s especially true today. After all, the past dozen years might have been history’s easiest time to invest, from a psychological perspective. The US stock market recorded a calendar-year gain in 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2019, 2020, and 2021. The only down year was 2018 when the S&P 500 dropped 4.38 percent.
Too many investors who began their journey after 2009 are saying, “Heck yeah, I can handle volatility, and I’ve proven it. Yet, despite no drawn-out drops, Morningstar found that investors underperformed the funds they owned by an average of 1.68 percent annually over the past ten years.
What does that mean? Basically, most investors mess things up, even when they’re easy. And when the next market crash comes, new investors will be tested as they’ve never been before. The good news is that diversified portfolios of stocks and bonds could help investors stay on track. Such portfolios won’t fall as far when stocks drop. And most importantly, that could help investors to keep investing money.
If you’re a new investor who still believes you have a high tolerance for risk, perhaps this ghost story might help. Sometimes we don’t know as much about ourselves as we think we do.
If you met me on the street and asked, “Do you believe in ghosts?” I would likely reply, “No.” But under certain circumstances, my behavior might betray me. Several years ago, I took twenty high school students to a remote Indonesian island. We stayed in a village with dirt walking paths. There wasn’t a single paved road. The families who hosted us lived on bamboo platforms perched over the sea. They didn’t have electricity or running water. Their outhouses were holes in the wooden decking over the sea. They lived much as their ancestors had.
We hired an American tour group who had built an educational retreat on a nearby island. Their leader’s name was Mike. We boarded several of their tiny motorboats and followed a river upstream, deep into the jungle. When the tide receded, the river became too shallow for the boats, so Mike led us on foot up a jungle trail. We then walked up a dry riverbed, scrambling over boulders. The students loved it, but it was hot and exhausting. When Mike eventually found our camping spot, we hung our hammocks, cooked and ate dinner, then headed off to sleep.
I woke up in the middle of the night to find a short woman in rags standing next to my hammock. Her long black hair obscured most of her face. “I told you not to come,” she said.
“I’m really sorry,” I replied. “Nobody told us not to come.”
“You have no respect,” she said. “So I’m going to kill everyone. You will have to watch.”
I begged this woman to spare us, swearing to leave in the morning and never come back. Then I woke up. We were on the equator. But I was shivering from the cold. It was the most terrifying dream I have ever had.
Shifting in my hammock, I looked slowly to my left. And there she was again! “We will never return here,” I whimpered. “Please don’t hurt anyone.” She replied, “If you promise never to come back, I will let you live.”
Then I woke up for real, freezing cold and covered with sweat.
The next day, I hiked beside Mike down that empty riverbed while describing my terrifying double dream. And for an eerie length of time, this normally chatty guy didn’t say a word. Then, with a touch of fear in his voice, he said, “We had a hard time getting a permit to camp at that spot. The nearby villagers said it was haunted. During World War II, Japanese troops slaughtered an entire village where we camped.” Mike still lives a short boat ride away. But to my knowledge, he hasn’t gone back to that site.
If you asked, “Do you believe in ghosts?” I would likely say “no.” But if you had the power to transport me, Star Trek–style, to that spot at night, I think my bowels would release and I would crash through that jungle like a man who had lost his mind. Yet, I say I don’t believe in ghosts? My behavior might be a more accurate barometer of my beliefs than my word.
Investors suffer from similar dissonance. They might say, “Yes, I can handle a portfolio with 90 percent stocks and just 10 percent bonds.” But when they face a prolonged period of horrible market returns, many of these self-proclaimed stoics will soil their own shorts. This reminds me of something former heavyweight boxing champion Mike Tyson once said: “Everybody has a plan until they get punched in the mouth.”
There are so many things we don’t really know about ourselves. That’s why we should temper our perceived tolerance for investment risk. When choosing an allocation between stocks and bonds, some people might select a high-risk allocation after seeing strong, historical returns.
But most people don’t know what they don’t know. They might select a high allocation of stocks, believing they can stay the course, but then a prolonged down market (and the economic news, which can freak people out) might chip away at the person’s courage. Wise investors respect what they don’t know about themselves.
Which Target Allocation Should You Choose?
The following table shows historical stock market returns for different allocations of stocks and bonds from 1926-2020.
Historical Investment Returns Depending On The Mix
|100% Stocks||80% Stocks20% Bonds||70% Stocks30% Bonds||60% Stocks40% Bonds||50% Stocks50% Bonds|
|Average Annual Return||10.1%||9.4%||9.1%||8.6%||8.2%|
|Calendar Years With A Loss||26/93||24/93||23/93||22/93||18/93|
|Worst Year||-43.1% (1931)||-34.9%(1931)||-30.7%(1931)||-26.6%(1931)||-22.5%(1931)|
Using U.S. stocks and U.S. intermediate government bonds
Portfolios with higher stock allocations earned better long-term returns. But if, after looking at the historical returns above, you believe you could handle a portfolio of 100 percent stocks, consider a portfolio with 80 percent stocks and 20 percent bonds instead. This portfolio won’t fall as far when the markets crash. And that subtle bond cushion might prevent you from freaking out when stocks crash or languish for years.
If, however, your gut says you could handle 80 percent stocks and 20 percent bonds, consider 70 percent stocks and 30 percent bonds.
After all, we don’t know what we don’t know. I won’t even ask if you believe in ghosts.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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