I walked into the school’s photocopy room and saw one of my fellow teachers. I’ll call her Kim. She looked a bit dazed, so I asked her what was wrong. “My portfolio has lost half its value,” she said. “I was watching a guy on CNBC’s Squawk Box last night and he said the markets will fall further than they did in 1929.”
“Are you sure you’re down 50 percent?” I asked. It was February 2009. From January 1, 2008 to February 28, 2009, the S&P 500 had fallen about 48.5 percent. The global stock index was down almost 52 percent. But I doubted Kim’s portfolio had been cut in half. Her bond funds, after all, would have tempered the fall. If her portfolio were 60 percent U.S. stocks and 40 percent U.S. bonds, her nest egg would have dropped about 25.6 percent.
“Kim, this is actually a really good opportunity,” I said. “If you sell some of your bonds and add the proceeds to your stock investments, you can take advantage of lower prices.”
“But I don’t own any bonds,” she said.
Kim was in her early 30s. When she first met her financial advisor, he would have tried to assess her tolerance for risk. He probably showed her a table similar to the one below. It shows how different allocations would have performed between 1926 and 2020, including their respective number of calendar year losses. Tables such as these, however, won’t give us an accurate assessment of our personal tolerance for risk. We just think it can.
Historical Investment Returns Depending on the Mix (1926–2020)
|100% Stocks||80% Stocks/20% Bonds||70% Stocks/30% Bonds||60% Stocks/40% Bonds||50% Stocks/50% 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|
|Calendar Years with a Gain||67/93||69/93||70/93||71/93||75/93|
|Worst Year||-43.1% (1931)||-34.9%(1931)||-30.7%(1931)||-26.6%(1931)||-22.5%(1931)|
|Source: Vanguard.com (using U.S. stocks and U.S. intermediate government bonds)|
Kim thought she had a high tolerance for market volatility. Unfortunately, she was wrong. Sometime in mid-2009, she capitulated and sold everything. Bombarded by news of financial Armageddon and seeing her portfolio sliced in half was more than she could take.
Kim re-entered the market a couple of years later. She paid 70 percent more for the same investments she had previously sold.
I had tried to convince Kim not to sell. But her emotions were stronger than anything I could say. On an intellectual level, she knew that diversified portfolios of stock market funds eventually recover after big declines. But it’s easier to understand something on an intellectual level than it is to master that knowledge on a behavioral level.
That’s why, when a young person asks me what allocation they should have in stocks and bonds I no longer know what to say. I used to say, “You’re young, so you shouldn’t have bonds,” or “You have plenty of time to recover if stocks fall, so perhaps you should build a portfolio with just 20 percent in bonds.”
But such advice implies I know something that I don’t. Furthermore, I have no idea how any individual would emotionally react to a market crash. And unless they had already been tested, that person wouldn’t know either. I wouldn’t count the mid-year drop of 2020 as a test. It was far too short-lived, and the markets went on to a big gain that year. Instead, I’m talking about a three-year crash, such as what occurred during 2000, 2001 and 2002. I’m also talking about the financial crisis of
Behavioral psychologist Daniel Kahneman says we aren’t good at predicting how we will feel. Whether it’s the happiness we might feel several weeks after buying a new car, how we might emotionally handle getting cancer or how we might handle a stock market drop, we’re lousy at forecasting our emotions.
That doesn’t mean, however, we can’t help ourselves a bit. That starts by understanding possible scenarios. In 2014, University College in London conducted a research study to predict levels of happiness based on different events. They used an app called The Great Brain Experiment and enrolled more than eighteen thousand people in their study. They found that personal expectations were the greatest predictor of our happiness. In other words, when we expect something fabulous and the outcome falls short of our expectations, we tend to get upset. But if we expect something bad and things turn out better than we thought they might (even if it’s still somewhat bad), we feel pretty good.
As an investor, you might be able to tolerate a high-risk portfolio comprising 100 percent stocks, or 80 percent stocks and 20 percent bonds. But ask yourself these questions:
- Could you handle multiple-year declines? During such a period, plenty of your friends will sell. As your portfolio keeps falling, you might wish you had, too.
- Could you handle seeing your friends with lower-risk portfolios earn more money than you for a year? How about three years? What about five years? Ten Years? Sixteen years? This could, and has, occurred.
I’m not saying everyone should pick a low-risk portfolio over a higher-risk portfolio. Long-term, diversified portfolios with higher stock allocations should beat diversified portfolios with lower stock allocations. But it might take several years before seeing that reward. High-risk investors aren’t really high-risk investors unless they can say, “Yes, I could handle a higher-risk portfolio that might, for several years, make less money than a low-risk portfolio as long as the long-term upside is better.”
In the table below, I’ve shown examples of three investors. They each have $10,000 on January 1, 2000, and they continue to add $1000 a month for almost 22 years. The first investor has 100 percent in a global stock index. The second investor has 80 percent in a global stock index and 20 percent in a global bond index. The third investor has 60 percent in a global stock index and 40 percent in a global bond index.
As shown below, after seventeen years of investing, the lowest risk portfolio was still ahead of the highest risk portfolio (see 2016 below). That’s after seventeen years of adding money every year. Seventeen years.
Do You Have The Patience and the Mettle for a Higher Risk Portfolio?
Starting with $10,000 and adding $1000 a month - January 1, 2000 to May 31, 2021
|Year End Portfolio Value||Total Sums Added||100% Global Stocks||80% Global Stocks, 20% Global Bonds||60% Global Stocks, 40% Global Bonds|
|2021 (to May 31, 2021>||$277,000||$789,449||$736,914||$682,039|
|Global bonds hedged to the USD - Source: portfoliovisualizer.com|
Kim thought she was a high-risk investor. But few people (if any) know their tolerance for risk until they’ve been tested.
So, if you think you could tolerate 100 percent stocks respect what you don’t know. Build a portfolio with 80 percent stocks and 20 percent bonds. If you think you could tolerate a portfolio with 80 percent stocks and 20 percent bonds, build a portfolio with 70 percent stocks and 30 percent bonds. If you think you could tolerate 70 percent stocks and 30 percent bonds, build a portfolio with 60 percent stocks and 40 percent bonds.
After all, how a portfolio allocation performs isn’t relevant. How you perform, with a specific allocation, is the only thing that matters. So respect what you might not know about yourself. That might be the key to helping you stay the course.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas