I realize that more money can be made in stocks if a portfolio contains some investing in areas that are a bit more risky
What is a good rule of thumb for diversifying a portfolio for growth, but an acceptable amount of stability?
Answers | 2
(b) over the long run, cash may barely keep pace with inflation, and bonds only beat inflation by 1-2% (with some exceptional periods with declining interest rates which are not likely to be repeated anytime soon. Cash and bonds are not in your portfolio to really make you money - they are there to provide diversification, lower the overall volatility of the portfolio.
So how much risk are you comfortable with? If you examine historical volatility and returns of portfolios composed of various percentages of stocks and bonds (as represented by pure stock and bond index funds) -- you'll find that adding just a little bit of stocks to the portfolio does not increase volatility much, but increases returns -- over long periods -- very substantially over an all-bond portfolio. Similarly, adding some bonds to an all-stock portfolio does drag down returns a little bit -- but drags down volatility a lot. So 100% bonds and 100% stocks are extreme portfolios which should generally be avoided unless you've got very specific reasons for being so extreme.
Somewhere in the middle of that range is the "sweet spot" -- where incremental additions of stocks add to returns without disproportionally adding to volatility. The last time I ran the numbers, the "sweet spot" was actually a pretty wide range - anywhere from about 50% to 70% stocks. Naturally, if you've got a very long time horizon and a high risk tolerance, it may make perfectly good sense to have more stock exposure than that -- but you've really got to know what you're getting into.
Anyway, a deeper discussion of risk, volatility, correlations, etc - way out of scope for an answer here. However, a very good rule of thumb is that if you have a moderate to long time horizon, (a) you need *some* stocks if you want any growth over time -- and any less than 30-40% should be because you absolutely can't have the volatility; and (b) you shouldn't have more than 70% stocks unless, again, you're certain you're prepared for that level of volatility; and finally, (c) stocks sometimes go down. Don't ever put money into stocks that you aren't prepared to lose *half* of in the short run.
(c) means that if you have a 60% stock / 40% bond portfolio, you need to be prepared to lose 30% of your money. If you can't stomach that, you've very possibly got too much in stocks.
Stability can be like teeter-tottering on a cliff. Are you balanced? We certainly hope so. Which is a greater risk. Staying there or getting the heck off that cliff?
Here are some great questions for investors to ask themselves:
1). Where are you financially?
2). where do you need to be financially?
It's not what you make, It's what you keep that determines your lifestyle.