What is a good asset mix?
I have heard a lot of talk on this topic, and there are a lot of simple rules that are ran through the media and personal finance circles.  They tend to vary on the theme that you should be heavier in stocks the younger you are.  One popular rule of thumb is to subtract your age from 100 to get the correct allocation of stocks for your portfolio.  These recommendations tend to get inflated towards a stock-heavy bias the more stratospheric the stock market gets, often at the investor’s detriment when things come crashing down.

I won’t rely on my own advice in this department as a mere peon, but will refer to the Abraham of value investing, Benjamin Graham,  who offered a different perspective in his book The Intelligent Investor.  First, he suggests that a portfolio strategy depends primarily on two things:

1. What is the goal for the investment? With this question, Graham suggests that age is not important, but investment time line.  A woman who is 90, but has a solid pension that she lives on completely, can invest her remaining portfolio completely in stocks with no real risk to her well-being.  A 25 year old, on the other hand, saving for a home in the next five years, has a very different goal and should invest more conservatively.  To this end, Graham encourages considering goals in the formulation of an asset plan.
2. What is cheap? Here is where Graham diverges heavily from the mainstream.  Graham, like most value investors, considers stocks and bonds — when purchased below fair value — risk neutral.  He suggests only that an investor, given equal value in both, favor bonds because of their higher standing in bankruptcy proceedings.

The practical application of this is that Graham suggests that an investor should shift to a higher bond allocation as stock prices increase, as measured by market price to earnings ratios (I discussed one way of doing this in an earlier post).  Such an approach would have saved millions of investors their 401K’s in the last year — as stocks increased to absurd highs in 2007, an intelligent value investor would have been almost completely allocated in bonds.

Graham Recognizes that We Are Dumb

As a hedge against our natural tendency to get great and seek higher returns, Graham suggests that an investor should — regardless of age — have at least 25 to 75 percent of his/her portfolio in treasuries, and investment-grade bonds.  In suggesting this, Graham points out — writing in 1949 — that there are significant periods of time when bonds outperform stocks and vice versa.  By maintaining a large bond portfolio, and investor does not get tempted into chasing stock returns when stocks are overbought, or when bonds are actually outperforming stocks over time.

What if I Am Lazy?

I don’t blame you if you don’t want to be constantly watching the markets and determining where the values are.  I enjoy it, but many don’t.  Graham also understood the need for people to have a worry-free portfolio.

For the lazy investor, Graham suggested an equal balance of stocks and bonds.  To best achieve this, the modern investor would invest half of their money in an S&P 500 index mutual fund, and half in a treasury and investment-grade bond index mutual fund.  I don’t like Exchange Traded Funds (ETFs), so I will ignore those, but they are an option that would achieve the same effect (even if I don’t recommend it).  The funds should be low-cost and no-load, and it is further advised that the investor have an international stock fund and an international bond fund (as much as 25% of the portfolio for each would not be too much), which will protect the investor from currency risk and an underperforming U.S. economy scenario.

Yeah, 50% in bonds, really. Think about that for a minute.  Not when you are fifty or seventy.  When you are 10, or 25.  I think most people today understand the wisdom in this suggestion, while I probably would have been booed off of the internet two years ago for suggesting it was a good idea.  People, just as they did in Graham’s day, fall in love with the adrenaline, thrill, and sky’s-the-limit prospects of the stock market.  The reality is that over any random period of time, your odds are roughly 50-50 in besting the bond market or not.  Repeat this to yourself:  bond is not a dirty word.

Update for Today

Things were a bit different in Graham’s time.  There were very few choices for investors.  Stocks or bonds.  That was it.

Today there are a lot more avenues for investment.  A good portoflio should include a fair mix of assets from other markets — including real estate (REIT funds), and commodities (oil, natural gas, agriculture, minerals — there are several broad commodity index funds to chose from).  Graham also discusse the potential value in a diverse portfolio of junk bonds, also known as high yield bonds.  Graham concluded that the average investor could not diversify enough in this market to minimize risk sufficiently, but today’s investor has access to hundreds of high yield bond funds that spread risk over thousands of bonds, and should definitely be in any portfolio.

So next time you read an article emphasizing the you-must-be-an-idiot-if-you-are-not-xy-percent-in-the-stock-market-or-you-will-die-poor-and-alone, think about the market today, and remember Graham’s advice.

Related posts:

1. How to Protect from Inflation
2. Are Stocks Cheap?

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