But even if you can't stand the stock market's dips and dives, some recent studies suggest it may make sense to own more stocks — up to 100% of your portfolio — if you don't need the money for 20 years or more.
The benefits of time - "Stocks aren't particularly risky if held for a long time," says Michael Finke, a professor of personal financial planning at Texas Tech University in Lubbock.
Finke recently co-authored a paper, Optimal Portfolios for the Long Run, to answer a classic question: What's the best mix of stocks, bonds and cash for investors with at least 20-year time horizons?
To find out, the researchers crunched 113 years of data on stock returns from 20 industrialized countries. They analyzed the returns across overlapping 20-year periods and plugged in formulas to see what the returns would look like for investors with various appetites for risk. They also factored in the "utility" to an investor of having the highest total portfolio value after 20 years.
The bottom line: To get "optimal" returns, even the most risk-averse investors should hold 71% to 80% in stocks. Moderate-risk investors should hold 81% to 90%, and investors with the highest risk tolerance should go all in, holding 91% to 100% in stocks.
Should you own more stocks? - Finke acknowledges that the study's conclusions may sound "crazy." And they shouldn't be taken as advice to dump your bonds and buy more stocks.
Indeed, while academic research may support loading up on stocks, investors need to consider personal factors.
For example, most advisers suggest trimming stock exposure as investors near retirement age and want more stable returns. If you need regular income, an optimal portfolio may include more bonds or other income-producing investments. And if your holding period is less than 10 years, some advisers suggest owning just 30% in stocks.
It's also crucial to know how you'd react if the market tumbled 30% in a short time — say six months. For many people, an "optimal" portfolio isn't one with the highest value after 20 or 30 years — it's one that lets them sleep at night.
"People care about short-term volatility," says Finke. "It makes them unhappy even if they're not spending the money." For these investors, it may make sense to hold less stocks since that may make them less likely to sell when the market is falling.
Time is on your side - If you can handle the bumps, however, studies do suggest that the risks of owning stocks drop over time.
Statistically, the market's average return typically bounces around by 21.7% over any 12-month period, according to research from Fidelity Investments. But that measure of volatility, called standard deviation, declines to 12% after three years. It drops to 8.8% after five years and dwindles to 1.4% after 30 years, according to Fidelity's research.
Essentially, that makes stock returns more stable than intermediate-term government bonds, which have a 2.5% standard deviation after 30 years.
Why are stock returns so volatile near-term and stable long-term? Investor behavior, for one thing. Despite lots of evidence that stocks are riskier in the near term, the average holding period for U.S. stocks is just one year, says Finke.
People care about short-term volatility. It makes them unhappy even if they're not spending the money."
Further, markets are driven by short-term factors like changes in corporate profits and the outlook for the economy. These things bounce around quite a bit quarter-to-quarter, jostling the market. Eventually, though, economic factors revert to long-term averages and stock returns follow a similar pattern.
Granted, this idea of "time diversification" — above-average returns offsetting below-average returns and lowering the risk of owning stocks over time — is controversial.
Some economists say it doesn't really exist since it would violate basic laws of finance. If the theory is right, they argue, long-term investors can earn higher returns with less risk by owning stocks — getting a free lunch compared to assets like bonds or cash. That idea — getting something for nothing — isn't supposed to happen, according to economic theory.
Yet evidence for time diversification exists in the real world, says Finke. It's been apparent in U.S. stock returns for more than a century, he points out. And there's now evidence for it in global markets, according to his unpublished paper, Optimal Portfolios, co-authored with David Blanchett of Morningstar and Wade Pfau of The American College.
A balanced approach - Even if you're not comfortable holding more stocks there are ways to potentially enhance your returns.
Rebalancing, for example, can boost your long-term results. People have a tendency to become risk-tolerant during bull markets — buying stocks when prices are high. And they grow fearful in bear markets, selling when prices are low. To avoid that mistake, you should set a long-term target mix for your investments and rebalance your portfolio once or twice a year.
Source: Daren Fonda, Fidelity Investments
The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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