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Asset Allocation for Young Investors: Go “All-In?”

Many people often say that the younger you are, the more heavily you should weight your portfolio toward stocks. Meg from “The Word of Wealth” recently wrote a post for All Financial Matters pondering the wisdom of the opposite point of view: Low-volatility portfolios for younger investors.

The line of thinking is that if you’re younger and you’re already investing, your money still has lots of time to grow. You can afford to earn a lower rate of return and still meet your goals. As such, perhaps there is no need to invest so heavily in stocks.

Hmm…I’d never looked at it that way. It’s certainly thought-provoking. That said, I’m pretty sure I strongly disagree with the idea. After all, are highly diversified portfolios of stocks (ie, index funds or other stock-based mutual funds) truly risky over an extended period? History indicates that they’re not risky. They’re just volatile.

The Conventional “Wisdom”

Essentially everything I read about investing (and I read a lot) says that every investor (no matter the age) should have some portion of her portfolio in fixed-income investments. As far as I can tell, this advice is base on the assumption that everybody has a certain level of volatility that they just can’t put up with–a certain degree of downward-price-movement at which point they’d panic and sell their stock holdings.

But I don’t think that’s true.

In fact, every single day recently I’ve been seeing evidence that it’s not true. I know from conversations with friends, siblings, etc. that some of them have had their portfolios decline in value by 50% (!!) or more this year. And guess what? They haven’t panicked. They haven’t sold out. They still own stocks. And they’re still funding their IRAs. [Side note: To anybody saying “hey that’s my situation exactly!”…You’re the Oblivious Investor that this blog is named after. You’re the hero of the story.]

It seems to me that if a person can deal with her portfolio value being cut in half over the course of less than 12 months, there’s practically nothing she can’t handle. She’s already proven that she has nearly 100% risk tolerance.

So my question is this: If you’re still quite young (20s), and you’re the type of person who would not bail out of equities even if your portfolio value declined by 50% in a given year…

Why not go 100% into stocks?

I’m genuinely curious. Is there something I’m missing here? Some reason that it makes sense to own fixed income even when you are looking at a several-decade time frame and you have near perfect risk tolerance?

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Comments

  1. I agree that a younger investor should invest much heavier in riskier assets such as stocks because of their time frame. However, I don’t think its ever good to have all of your money in one asset class. The 100 percent stock portfolio is much more vulnerable to systematic risk.I would say 80 to 90 percent is very aggressive. The 100 percent stock portfolio is for the investor that would be just fine if their total investment went to 0.

  2. Well, I think the best argument is that, statistically speaking, a 5-10% allocation to bonds will go a long way towards damping volatility but will barely reduce returns at all. The law of diminishing returns applies to equities as well. After a certain percentage of your portfolio is in equities (maybe 75-80% or so) the additional return you can expect gets smaller and smaller compared to the additional volatility. After a certain point, it’s not really worth it anymore. In the real world, a 100% stock portfolio isn’t likely to outperform a 90% stock portfolio by a significant amount. It will be much less volatile, though. To some people the tiny extra return may be worth it, but most investors would probably prefer a smoother ride.

  3. Mike,

    Great post. I’d say I have to agree with you. For a young investor, it doesn’t make much sense to go with anything less than a 100% stock portfolio unless you’re really risk averse.

    Oddly enough, I just finished a post about a diversified 100% stock portfolio that will be published tomorrow (December 2, 2008). I cover some quick facts about this type of portfolio. I could have included a lot more, but I think those detailed numbers bore most people and don’t make sense to many more. (I know you’re an exception to both.)

    I have a lot of good data on portfolios like this. Let me know if you ever have some burning question that you’d like to know the answer to (from a historical perspective).

  4. Well, for starters, we have to consider that the average investor isn’t invested personally in stocks, but rather indirectly through mutual funds. Yes, there are many who have presence in the stock market, and yes, many also who hold their own shares of company stock where they work. But outside of that, more still own shares of mutual funds, and those funds themselves can be a mixed bag of stocks, bonds, derivatives, etc. So for many, they are acually already getting the exposure that you are talking about, they may just not realize it.

    Now with that being said, I am an absolute proponent of being 100% in stocks ( even through your mutual funds ) for a very, very long time. Why? Because many of these stocks that you own supply you with not only appreciation but also dividends, and those payments help you to generate income with little to no effort and provide an offset during market declines.

    So I echo your sentiment of being more heavily invested in the stock market in general, and for those who are more risk averse, look to holding balanced funds and growth and income funds to give yourself some “security” ( pun intended!! )

  5. I’d say don’t go 100% into one asset class — keep some cash out. Thie ensures you can execute on deals that pop up immediately. Nothing sucks more than seeing some crazy deal pop up and not be able to execute trades RIGHT THEN.

    Another thing to remember is that the market dropped 89% during the depression. 50% is nothing. It started at a high of 311.90 on 11/29/29 and bottomed at 33.98 on 7/7/32. Think it can’t happen again? I hope not as well. But don’t think that just because we’re down 50% that it cannot go further.

    “Investing” into this market isn’t really investing — it’s gambling. Sure, plenty of people are making lots of money… but for every person who makes a dollar in the market, someone lost one somewhere. It is nearly a zero-sum game.

  6. I completely agree, at least in investments for long-term goals like retirement. It also doesn’t hurt that at a young age, the value of these accounts are relatively low, so a 50% drop in dollar value isn’t as significant as it may be for an older investor.

    For more medium and short term goals though, you have to weigh your acceptable timeframe.

  7. @Greg:

    For short-term traders, the market might be a zero-sum game. For the long-term, it’s nowhere near a zero-sum game.

    While the value of a stock is the agreed upon price between buyers and sellers, it’s important to remember that over the long term the stock price reflects the value of the company.

    If the company grows and becomes more valuable, the stock price will rise. This is not because another investor lost money (zero-sum). It’s because the company performed well and managed the business well. Growth on that basis doesn’t require another investor to lose anything.

  8. By holding some of your portfolio in bonds and rebalancing frequently, you lose less when the market crashes and thus have more money to buy stocks at lower prices (especially if you reduce your bond allocation to 0). I haven’t done the math for how profitable this is.

    Right now I hold no bonds, but once the market recovers I’ll add a small portion to my asset allocation.

  9. I know it’s an over-used term, but you have to consider the Black Swan effect. Something that comes along that crazily hits one asset class. Say, for instance, some political reversal that hits equity investors but leaves debt owners or savers alone.

    We got a good warning in 2008 to think the unthinkable…

    By the way, you have great comments on your blog. If I had such comments I’d have left the option to add a comment open on Monevator.

    Oh well, will just have to come here for my chatting! 🙂

  10. @Monevator, I couldn’t agree more. I’m lucky to have several great, regular commenters (as well as plenty of other intelligent/insightful people who’ve stopped by to add their say).

  11. I am reading this from the standpoint of being a 25 year investor that unfortunately went “allin” a bit too soon. I had never really got my financial situation intact after college and thus all my money was sitting in either checking or some savings. I never had the time to look into my investments as I was working 80 hour weeks for quite some time. After my job settled down I decided to invest all of my savings that were earning little or no interest into a few different mutual funds. This was between Feb-March of 08. If only I had known to wait a bit longer…

    @Pete, I realize the dollar amount might be significantly less when you are younger, but the compounding of that small amount of money over the next 30 years could easily prove to be much larger than the amount you are referring to. I still get sick thinking about losing the money I did.

    I have learned a lot in the year since I last went “allin” and have done a lot more trading and less buy and hold. I have seen marginal gains, but I also didn’t lose 40%. I believe a support line exists somewhere around 8,000 for the Dow and I am now again looking to possibly dump a ton into small and mid cap indexes.

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