After the invention of high explosives and accurate long-range mortars and artillery, combat soldiers did not stand a chance of making it out alive if they didn’t have a shelter that could withstand nearly anything. The advent of the bunker allowed many to stay alive. Let’s keep this bunker metaphor in mind when we are searching for the ideal portfolio allocation. It needs to be able to withstand anything the economy and the market can throw at us so that we emerge unscathed. We must fight our basic human natures when we do this. Your instincts will inevitably lead you down the wrong path.
For your retirement account to be a bunker for your savings, it must be able to withstand any assault. It must grow in times of high inflation, and in times of low inflation. It must work well in times of low-interest rates, and it must perform well in times of high-interest rates. It cannot be crushed with equities are out of favor, and the market is bearish. What you ultimately want to accomplish is being able to go to bed at night knowing that your bunker protected your hard-earned money and that it grew a little that day. The ultimate test of a well-designed portfolio is that you can sleep well at night, and you do not really care what the market does.
Always remember that there is no free lunch on Wall Street. You must take on at least some risk of you want your money to grow. In our discussion of stock picking, we learned that stock sectors are highly correlated, and you never want too much exposure to a single sector. We certainly don’t want too much exposure to a single stock. By the same logic, we must realize that we don’t want too much exposure to stocks. In other words, we don’t want to over-allocate any particular type of financial instrument.
All our lives, we have heard that you don’t want to “put all of your eggs in one basket.” This is the essence of why we need to diversify our portfolio. Tech stocks have had a great run, but buying a single, huge basket of tech stocks would be folly. That basket could be crushed because the market decides that tech isn’t fashionable this year. That doesn’t say that it is wrong to put some of your money into tech stocks, but it does suggest that this be one small basket among many in your portfolio.
The real trick, then, is to figure out how many baskets you need and what goes into each basket. Unfortunately, there can be no universal prescription. Since this is the most important decision that you will ever make, you want it to be right for you. We can generalize a few key concerns that everyone needs to take into account. The first is your risk tolerance contrasted with the risk you can afford. Each year that passes, you need to take a little bit less risk. If you are 22 years old and starting your first real job, then you can afford to take some big bets. You will not have much to lose at first, and achieving high growth early on is a very attractive prospect given the way that the magic of compounding works. If you screw it up and lose some money, you have your whole career ahead of you in which to make up the losses.
By the time you retire, you will want to make capital preservation your number one priority. You need your retirement fund to live on, and substantial losses can have a substantial impact on your quality of life. If you start out with a high-risk tolerance, you may have to force logic onto your inner gambler as you grow older. If you were born risk-averse, you might have to force some risk onto your inner caution. The allocation of risk over time needs to be a function of your portfolio strategy; you must ruthlessly suppress your emotions and formulate a logical plan to meet your objectives, and then stick to it no matter what (unless your strategy becomes illogical over time).
Therefore, we need to protect against the downside, but we must also achieve some degree of upside that will help us accomplish our goals. For example, if you only save $100 per month in a portfolio that nets you 2.5% annually, you will have around $52,700 to retire on. No matter how frugal you are, that isn’t going to cut it. You could only withdraw $2,100 per year without depleting your principal. If you invested the same money over the same period at a rate of 10%, then you’ll have $197,000. That’s enough to generate $7,880 in yearly income during retirement. That isn’t enough for most of us to get by on, but it hopefully proves the point that actualized interest rates really, really matter.
Last Updated: 6/25/2018