Traditional financial wisdom says that the best portfolio is 60-40, with 60% of your money in a diversified pool of stocks and 40% in high-quality bonds. Any additional stock allocation leaves you vulnerable to a market downturn.
The stock market can be unpredictable. But that shouldn't scare off those longer term investors who don't rely on portfolio income to meet regular or major expenses. If you have that kind of financial patience, a portfolio with 90% in a stock index and 10% in bonds will do much better.
Look at the large and growing differences in total returns between investing $100,000 in a 90-10 portfolio versus a 60-40 portfolio over time:
Critics of the 90-10 portfolio often point out, correctly, that equities usually fall much further than bond prices when markets decline. This argument ignores reversion to the mean, a critical dynamic for long-term investors. In the past 60 years, the three years that suffered the worst total returns were 2008, 2002, and 1974 -- but in each of those years, the index rebounded quickly, with large positive returns in following years.
What about periods of consecutive down years for the S&P 500?
In the past 60 years, there was only one period of three consecutive down years for the S&P 500, from 2001 to 2003. However, the losses from that period were more than recouped by the end of 2006. There has only been one instance of two consecutive down years for the index, from 1973 to 1974, due to a global oil embargo. The index more than recovered by the end of 1976.
Mean reversion happened again this year. The S&P 500 was down 7.3% year to date on March 30, mainly due to the Iran war. But the index bounced back to plus 5.6% year to date by May 1.
A common piece of financial advice suggests investors need lots of bonds to offset down years in stocks. It's worth noting that only 10 times in the past 60 years have positive bond returns actually offset negative S&P 500 returns to some degree. Although rare, bonds sometimes even move downward with stocks. Total returns of 10-year Treasuries were negative alongside the S&P 500 in three years of the past 60 years. In 2022, for example, the total returns of the S&P 500 and 10-year Treasuries were both close to -18%.
Bonds just aren't as attractive as stocks. While the positive returns on stocks are driven mainly by the growth of company earnings, the returns on bonds are driven mainly by interest rates, which depend upon macroeconomic conditions and government policies. In inflationary periods, interest rates are high and bonds do poorly. And although high interest rates can also adversely affect stocks, successful companies have leverage. They can raise prices, control costs, and increase earnings.
As a result, the returns of stocks are better than those of bonds in most inflationary periods. When annual inflation averaged more than 8% between 1972 and 1982, the average nominal total returns of the S&P 500 were 7.7%, as compared with 5.7% for 10-year Treasuries. During a more recent inflationary period, 2021 to 2024, the annual nominal total returns for the S&P 500 and the 10-year were 13.5% and -5.4%, respectively.
American investors may be suffering from recency bias toward bonds: In the decade after the financial crisis of 2008-09, bonds did well as interest rates dropped and stayed low. However, that scenario isn't likely to recur. Interest rates are normalizing at a higher level and inflation may be structurally elevated. Inflationary pressures just keep building, in part due to the government's fiscal profligacy.
Recent Democrats and Republican administrations have both run enormous budget deficits, even in years with strong economic growth -- and there is no sign they plan to change course soon. When Medicare and Social Security become insolvent in the next decade, Congress will have to bail them out by issuing more debt. All this additional debt will increase inflation, which in turn increases interest rates, pushing down bond prices. Stocks will continue to look all the more attractive.
If you choose to hold a 90-10 portfolio, however, you will need a plan to stay calm in the inevitable down years of the stock market. Even investors who give lip service to a long-term approach are sometimes swayed by short-term market movements. When stock prices drop sharply, investors often sell shares and then struggle to find the right time to get back into the market. For this reason, the average retail investor in equity funds has underperformed the S&P 500 by roughly 3% a year, according to the market-research firm Dalbar.
Here are some suggestions to avoid panicking when stocks swoon. Consider a down year as an opportunity to buy stocks cheaply. Remember that the stock market's worst years are regularly followed by years with positive returns. And think of the 10% you have in a money-market fund as an insurance policy, in the unlikely event that the stock market stays down for two or three consecutive years.
This plan works even for those nearing retirement, who historically have had a shorter investment horizon and can't wait for stocks to rebound from a downturn. But as life expectancy grows, 65-year-old retirees are now likely to live to see another 15 years of portfolio gains. And many investors who don't need their portfolios to meet their living expenses plan to bequeath their stocks to their children, extending their investment horizons far into the future. (Their children won't have to pay capital-gains taxes on any increases in stock prices during their parents' lives).
Investing in stocks is always a risk. But the historical data show the risk might not be exactly what advisors have ingrained in retail investors for decades. For those with a long-term investing mind-set and the stomach for riding out the market, 90-10 may be your best play.
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