Tuesday, September 4, 2012

The big question: Risk vs Return, Part 6

Having discussed the risks and returns of two types of traditional investment vehicles, now let's conclude this somewhat long series :)

Now I am a young person, with a steady income, not very risk-averse, and have a financial goal that I want to meet in about 5 years' time. So my personal asset allocation would be this:

international stockus stocklong-term bondintermediate-term bondconsumer lending
20.00%30.00%20.00%10.00%20.00%

Now I have not discussed consumer lending yet, for now, just understand then as short-term, high credit risk bonds.

So I have a 50-50 split between stocks and bonds.
I am not sure about how this allocation will turn out to be, since I am myself a new investor even though I've done my research. As a general rule, the more risk averse you are, the more you should allocate towards bonds. Even though bonds just had a gigantic decade long bull market, I am personally rather pessimistic as to bonds' performance over the next decade.

I've some data here that you might want to consider when you decide your own asset allocation. Keep in mind, the most important factor here is your time horizon: if you have 20 years or even 30 years, you will be much better off with riskier allocation as they generally return more over time.

Stock percentageBond percentageAnnual return 1926-2011
01005.6%
20806.7%
30707.3%
40607.8%
50508.2%
60408.6%
70309%
80209.4%
10009.9%

The assumption here is that you invest in very broadly diversified stock and bond funds with zero expense ratio, like funds that track MSCI US index for stocks or Barclays US Aggregate Float Adjusted index for bonds. Of course, no fund is without expense ratio, therefore, your return will always be slightly lower, probably by less than half a percentage point if your fund is relatively low cost. 

The conclusion should be that the more stocks you have, the higher return. So what about risk? Now here it is:

Stock percentageBond percentageNumber of years with loss
010013
208012
307014
406016
505017
604021
703022
802023
100025


So generally the number of years that a loss occurs increases as you allocate more of your asset in stocks.

This should hopefully help you decide how to allocate your assets. :)

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