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With that in mind, perhaps you can see why your most important investment decision is how much of your portfolio is allocated to stock-type investments and how much to fixed income securities like 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 dictate future returns ? it also tells you a great deal about how those results are likely to be obtained. Look at the charts linked to below.

Charts: Volatility Goes Down When Your Bond Allocation Goes UpThe vertical lines represent the returns for each calendar quarter between 1989 and 2003, ranked from worst to best. Starting with Chart A, you can see that a 100% stock portfolio is going to provide many quarters of big moves, both up and down. The other charts reduce the stock portion in increments of 20% each, putting that money into 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 quarterly losses in 28% of the periods shown compared to 17% of the time for the portfolio invested just 20% in stocks. 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 of 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 very 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 less 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 exclusively in stocks. They can afford to ignore the short-term ups and downs, while racking up 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.

While the charts in this article may overstate the absolute returns you can expect from each portfolio (the period shown was especially strong for both stocks and bonds; the long-term averages for all five portfolios shown are roughly 1 percentage point lower), they accurately illustrate the relative returns you can expect from each allocation mix. That is, in stepping down from Chart A to Chart B, the worst case scenario is reduced by nearly 1/4th (from -16.8% to -12.7%), while the average return declines only about 1/20th (11.9% vs. 11.4%). In other words, volatility declines more quickly than returns do, meaning you can afford to add bonds for stability without reducing performance too drastically. This is why we advise readers who feel a need to temporarily lower their risk to make only small changes (rather than large adjustments) to their portfolios. Short-term risk can be reduced significantly just by moving one notch to the right, say from Chart B to Chart C, without dramatically lowering the long-term results you can expect.

Hopefully this article helps clarify the relationship between volatility and expected returns, and how the allocation of a portfolio is the primary driver of both. If you’re nearing the end of your investing time frame (whether for retirement, college, etc.), this information should give you confidence that you can keep growing your money at a reasonable rate even if you do the prudent thing and increase your bond holdings to reduce the chance of short-term losses. On the flip side, if you still have many years to invest, hopefully this will liberate you from worrying about what the market will do in the short-term as you ramp up your stock allocation to take advantage of the higher long-term returns stocks have historically provided.

© Sound Mind Investing

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