Key takeaways
- The split between stocks and bonds explains most of how a portfolio behaves. Which fund you picked explains far less.
- Allocation is a risk decision first. The return follows from the risk you agreed to carry.
- Diversification reduces the risk of any one holding sinking you. It does not reduce the risk of markets falling together.
- The mix you can hold through a bad year beats the mix that looks best on paper.
The mix does most of the work
Ask someone how their investments are doing and you will usually hear about a holding. The holding is rarely the story. A portfolio that is 80 percent stocks behaves like a stock portfolio no matter which stock funds are inside it.
This is the finding that made index investing respectable. Once you have chosen how much of your money sits in equities, you have already decided most of what will happen to it.
You are choosing a bad year, not a good one
Allocation reads like a return decision and behaves like a risk decision. The honest way to set it is to look at the downside first.
An all equity portfolio has historically fallen by half. That is not a tail scenario invented for a disclaimer. The S&P 500 fell 49 percent from 2000 to 2002 and 57 percent from 2007 to 2009. Both took years to recover. If you would sell at the bottom of that, you do not own an all equity portfolio, you own one until it matters.
Bonds are in the mix to make the bad year survivable, not to make the good year better.
What diversification does and does not do
Spreading money across many holdings removes the risk specific to any one of them. The research on how many names you need has moved around, with classic studies landing anywhere from ten to forty, and the practical answer for most people is a broad index fund that holds thousands.
What diversification cannot do is protect you from everything falling at once. In a real panic, correlations rise and most things go down together. Diversification is protection against being wrong about one company. It is not protection against a bad decade.
The mix you can actually hold
The best allocation on a spreadsheet is worthless if you abandon it in March of a bad year. A slightly conservative portfolio held for thirty years beats an aggressive one held for six.
Pick the mix whose worst year you can describe out loud without flinching. Then write down why you chose it, because the reason is what you will need when the number is red.
Sources
- Drawdown figures for 2000 to 2002 and 2007 to 2009 are peak to trough declines in the S&P 500 index level.
- The attribution finding originates with Brinson, Hood and Beebower and has been debated and refined since. The durable point is the ranking, not a precise percentage.
- Diversification thresholds vary by study. Evans and Archer suggested around ten names, Statman argued for thirty or more.
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