It's not hard to find people who criticize the idea of investing a portfolio entirely in stocks. They often make some very strong points in favour of including some fixed-income investments in a portfolio. My purpose here is to defend the all-stock portfolio for the right investors.
Let me start by saying that an all-stock portfolio is not for everyone. In fact, it probably only makes sense for a small minority of investors. The arguments commentators make against an all-stock portfolio effectively identify people who shouldn't own 100% stocks.
Let’s look at some of the pros and cons of an unleveraged diversified portfolio of all stocks.
Pro: Over the long run, stocks have outperformed bonds.
This is the only important advantage of stocks over bonds. Over long periods of time, stocks have consistently outperformed bonds. The hope is that this will continue. There are good reasons to believe that it will continue. People tend to be risk-averse and will demand a higher return for accepting risk.
Con: Stocks can crash and takes years to recover.
This is true. However, for stocks to continue to outperform bonds over the long term, the period after a stock market crash must have large enough stock returns to offset the crash and overcome the steadier bond returns. But this only helps the investors who stay the course. If an investor panics and sells, he or she will miss out on the recovery. There is no guarantee that the recovery will come quickly, but recoveries have always come along eventually.
The recent stock market crash in 2008 and 2009 was a good test of investors’ temperament. Author Derek Foster was well-known for advocating stock-based investment strategies, but lost his nerve and sold at a bad time. This shows that even apparently knowledgeable and experienced investors can find that they don't have the temperament for an all-stock portfolio. Foster would do well to balance his portfolio with some fixed income to avoid a repeat of his costly mistake.
This period was a good test for me as well. I’ve lived through more minor stock market declines, but this was a big one for me. Fortunately, I passed. I spent the time I devoted to investing gathering my nickels to buy more stocks rather than biting my nails while wondering when I should sell out.
Con: During market declines, withdrawals can decimate a stock portfolio.
This is very true. It makes no sense for retirees or anyone else who needs to draw on their portfolios for income to be 100% invested in stocks. This can even apply to people who might need to make withdrawals. If losing your job during a market decline is a possibility that will lead to drawing on your long-term savings, you should consider allocating some of your money to something less volatile than stocks.
As a rule of thumb, investors should consider safe investments for any money they might need in the next three years. More conservative investors may choose five years instead.
Con: The high volatility of stocks keeps investors up at night.
A decent night's sleep is important. It makes little sense to live in fear. Each investor has to choose a level of volatility he or she can live with. However, don't delude yourself. Over the long run, GICs have had significantly lower returns than stocks. If you make a choice for calm over the potential for higher returns, this might be the right choice for you, but it won't change the fact that you are very likely to underperform stock market indices over the long run.
Most people are not good candidates for an all-stock portfolio. It may even be true that most people who think they are good candidates for an all-stock portfolio really aren’t. It’s hard to know how you’ll react to market declines until you live through them. The recent crash of 2008 and 2009 should have given you some clue about your investing personality. If you confidently ignored all the doomsday talk of the death of stock investing, you may be a good candidate for an all-stock portfolio. If you got caught up in all the negativism in even the slightest way, consider a less volatile portfolio make-up.