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April 29, 2010

Financial Literacy 101: Your most important investing decision

Ninth in a series for
Financial Literacy Month

April is National Financial Literacy Month — and at SMI we've been doing our part with a series of posts on basic principles of investing and personal finance. (Each post in the series is identified by the orange character at right, diligently working on his financial plan.)

Here's our final post in this series, with advice on the one investing decision that will have greatest impact on your eventual returns.

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What determines the performance of your investment portfolio more than any other single factor? Many investors think it's the specific investments they choose. Certainly that can make a big difference.
But even more important is how much of your portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. Academic studies over the years have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.

A portfolio's stock-to-bond mix does more than dramatically influence future returns — it also tells you how those results are likely to be obtained. Look at these charts. The vertical lines represent the returns for each calendar year between 1926 and 2008, ranked from worst to best.

Starting with Chart A, you can see that a 100% stock portfolio is going to provide many years of big moves, both up and down.

The other charts reduce the stock portion in increments of 20% each, putting that money into intermediate-term government bonds instead. This has the clear effect of narrowing the range of results. Not only are the bars on the other graphs smaller (illustrating that the gains and losses of these portfolios are less extreme), but the frequency of negative returns declines as well.

The 100% stock portfolio suffered losses in 29% of the years, compared to just 10% of the years for the 20% stock portfolio.

It's safe to say then, that the more bonds in your portfolio, the smoother the ride. By contrast, the higher your stock allocation, the more you can expect returns to come in a "two steps forward, one step back" fashion.

If owning stocks subjects you to greater swings in performance and produces losses more frequently, why use them at all? Because that's where the biggest long-term gains are! The net effect of all those stock market ups and downs is greater overall returns, which you can see in the average annual returns shown on the charts.

So, on the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?

The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be quite confident that stocks will provide higher returns than bonds.

Here's a good example to illustrate this point. Think about tossing a coin. You know that the probability of getting heads on any single toss is 50%. So if your goal is to get 50% heads, then what matters most to you is having a lot of tosses. If there are only going to be two tosses, you should be much less confident of getting 50% heads than if there are going to be ten tosses. With 100 or 1,000 tosses, your confidence should grow correspondingly that the long-term averages will emerge.

So it is with investing. The more years ("tosses") you have ahead of you to invest, the more confident you can be that you'll benefit from the higher average returns stocks have historically provided. The fewer years you have to invest, the more you need to protect against the possibility that the results over your shorter time period may not match the long-term averages.

That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.