Typical advice on asset allocation is that you should put fixed percentages of your savings into each of stocks, bonds, and cash. Usually, the advice is that the percentage in stocks should go down as you get older. I’ve never understood this rigid approach to investing. It makes no sense to me.
The theory is that this approach will reduce risk, particularly as you get older and closer to needing the money for retirement. I think the use of the work “risk” here is misleading. We are really talking about volatility. The asset allocation advice is designed to reduce the volatility of your year-to-year returns. But, you pay for this lower volatility with lower long-term returns.
To illustrate what I mean, consider the following example. Suppose you win a raffle, and your prize is that you get to grab a fistful of cash out of one of two large buckets with your eyes closed. One bucket has just twenty-dollar bills, and the other has half tens and half hundreds. If we say that you could hold about 100 bills in one hand, then the first bucket will give you a predictable roughly $2000. The second bucket will give you between $1000 and $10,000, a much more uncertain or “risky” choice. It’s not too hard to see that the second bucket is worth the added risk.
Over the long term, stocks have been a much better investment than bonds or cash, and there is every reason to believe that this will continue. Why should I put any money in bonds for the long term if the odds are overwhelming that the stock market will give me a higher return?
Here is how I see things. Cash is for short term needs, say for the next 6 months. I keep cash as an emergency fund as well. The size of your emergency fund is a personal choice, but it should be higher if your income is variable or at risk in some way.
Bonds are for known big expenses coming up in the next 3 years (or 5 years if you want to be more conservative). The taxes you owe next April and the down payment on the house you plan to buy in 2 years shouldn’t be in stocks; bonds that are timed to come due when you need the money are a better choice. I prefer to buy actual bonds (or other government debt) rather than paying the MER on a bond fund.
All money I don’t need for at least 3 years goes into stocks. This can be individual stocks if you are skilled at analyzing businesses, or it can be a low cost index fund for those who want to put their stock investments on autopilot.
With this approach, you could be 90% in stocks if you have no big financial obligations coming up. Or you could be 75% in bonds if you are planning to buy the other half of the family cottage from your sister soon. The financial realities of your life dictate the appropriate mix of stocks, bonds, and cash rather than some pronouncement from a supposed financial guru.