Choosing An Asset Allocation (How Much Is Stocks vs. Bonds?)

Introduction – Understanding Risk in Investing (0:00)

Bo: Risk. It’s one of the biggest variables in personal finance, but it’s the one that very few investors actually understand. And risk is a crucial concept to understand when evaluating the portfolio breakdown that’s right for you. We’re going to look at risk a little more in-depth. What the data says about asset allocation and how you can apply it to your own financial situation. Helping people make more informed decisions with their money gets me so excited. So, with that, let’s dive in.

The Three Components of Risk Profile (0:26)

Bo: When most people think of risk, all they think of is how much money they could lose in an investment. And while that is a part of risk, they’re missing some big pieces of the puzzle. Risk is made up of three main categories, which together we call a risk profile. Two of these components you’ve likely heard of, but the third doesn’t get talked about as much.

Component 1: Behavioral Loss Tolerance (0:44)

Bo: First is called behavioral loss tolerance. Sometimes referred to simply as risk tolerance. Behavioral loss tolerance, put simply, is your ability to sleep at night without panicking and selling your investments. It might shock you to learn that although risk tolerance is perhaps the most subjective of the three, it is a binding constraint on asset allocation. What that means is that it’s not sustainable to have a portfolio that exceeds your risk tolerance. We can throw any amount of data at you that we want, but ultimately if you’re going to sell at a certain point, regardless of what logic would indicate, it doesn’t matter what you should do.

Bo: Now, that said, risk tolerance is not an immutable variable. It’s very likely, in fact, that your risk tolerance will actually change over time. Factors like age, stage of life can have pronounced effects on your risk tolerance. You may be cool to cowboy it up as a single guy in your 20s, but when you’re 40 and married with two kids, your comfort level with risk is likely to decline. But there are also variables that correlate with an increase in risk tolerance, two of which are financial knowledge and investing experience. The more knowledgeable an investor is about historical market performance and the more time they’ve spent in the market and witnessed volatility, the more comfortable they tend to be when seeing their portfolios drop. I can tell you this firsthand. Managing money in 2008 looked very different for me than managing money in 2022.

Why Risk Tolerance is a Binding Constraint (2:05)

Bo: The key reason that this element of risk is a binding constraint on asset allocation is that when making emotional investment decisions, investors tend to sell at some of the worst times. So, it’s generally a more prudent strategy to choose a portfolio that you can stick with through good times and bad, even if it’s not necessarily the optimal choice. If you have an asset allocation that you cannot touch and feel okay about, that is more likely to be a successful strategy for you. And for those of you sitting there thinking, I can take all the risk in the world, bring on those huge market swings, you should know that a Morningstar study of hundreds of thousands of investors found risk tolerance to be normally distributed, which means the vast majority of folks are only tolerant at most to a moderate amount of risk. While it’s possible you can really weather serious volatility with no sweat, be honest with yourself when evaluating your risk tolerance.

Component 2: Risk Capacity (2:58)

Bo: The next component of risk profile is risk-taking ability. This is often called risk capacity. This is an investor’s ability to hold an asset in the short term without needing to sell it for access to liquidity. And for this reason, risk capacity is another binding constraint on asset allocation. Even the most risk tolerant person in the world can’t invest the money they’re about to use to feed their family. This can also be thought of as the amount you can put away without compromising the stability of your life situation. Risk capacity is made up of a few variables. One of which is time horizon or how long before you need the money. Although it’s not often talked about in these terms, this is one of the key benefits of starting early. It can allow investors to take on more risk.

Component 3: Risk Need (3:39)

Bo: And the last component of risk is risk need. This is the level of risk an investor needs to take on in order to reach their financial goals. For example, let’s say that two investors start investing $1,000 a month at 25 years old. One wants to reach a $2 million portfolio by 60. The other wants to reach that same value by 50. The first investor only needs to average a 7.1% rate of return while the second would need an 11.7% rate of return and thus a far more aggressive or risk-on asset allocation. In that case, with such a high risk need, it may be prudent for that investor to alter their time horizon or to adjust their savings accordingly. However, it’s crucial that we as investors don’t chase returns and take on undue risk in order to take shortcuts in achieving our goals. After all, if the financial goal can be reasonably achieved by taking on less risk, why would we take on more? It is possible that there are valid reasons to do so, like having more flexibility sooner. But it is a question worth asking, and it’s crucial to take the right kinds of risk.

Compensated Risk vs. Uncompensated Risk (4:40)

Bo: Return-driven investors often attempt to assume more risk and in theory higher return by concentrating their investments into one industry or one company. That’s often the wrong type of risk. A higher return can be expected for diversifying across a risk-on asset type like holding a bunch of different stocks. This is what’s known as compensated risk. However, that does not apply to individual assets of the type. That is considered an uncompensated risk. This means increasing your equity exposure from 25 to 50% would increase risk, but it would also increase expected return over a long time horizon. While holding 50% of your portfolio in a single stock would also increase risk, it likely would not increase your expected return over that same long time horizon. Understanding risk need can be a valuable metric for evaluating whether a more aggressive or conservative asset allocation might be more appropriate for your situation.

Risk and Asset Allocation (5:37)

Bo: But let’s look closer at what that means and how risk impacts asset allocation. If we broadly characterize equities as risk-on assets and bonds or fixed income as risk-off or risk-reduced assets, we can then evaluate the question of how much I hold in stocks versus how much in bonds as a question of how much of my portfolio should be risk-on and how much should be risk-off or risk-reduced. It’s important to note that even assets that are viewed as less risky like bonds or fixed income assets carry a non-zero level of risk. All assets and investments carry some risk which includes a risk of loss. And that’s a risk that you, the investor, takes on when making investment decisions.

What the Research Shows (6:19)

Bo: But we can look to the data and see how to evaluate asset allocations through this lens of risk. In 2024, the CFA Research Institute analyzed what they saw as optimal asset allocations over different periods. And what they found was that as the time horizon for an investor increased, the optimal equity allocation increased with it. Even investors that were classified as highly risk-averse were found to have an optimal asset allocation consisting of over 60% stocks. Those more comfortable with a higher level of risk were found to have optimal allocations of stocks around 80%, sometimes nearly 90% depending on the risk profile. It’s important to note that optimal can mean different things to different investors. This is simply their definition of what’s optimal.

Bo: Other research though comes to even more aggressive conclusions. A paper published by the American Economic Association in late 2024 suggests that despite higher volatility, a 100% equity portfolio is the least risky option over long time horizons, including for retirees. Altogether, that means that even for the most risk-averse investor, a 60/40 stock-bond split was found to be optimal over a long time horizon. Most folks with moderate risk tolerance would fall somewhere between a 70/30 or 80/20 stock-bond split with the most aggressive investors seeing near 100% equity exposure.

No One-Size-Fits-All Solution (7:39)

Bo: Does that mean that one of these is the right fit for you or that you’ll fit squarely into one of these asset allocations? Not necessarily. Because at the end of the day, while these can be useful guidelines to construct a portfolio, we can’t give you the objectively optimal asset allocation because it doesn’t exist. The truth is every investor’s needs and preferences will change not only from investor to investor, but even for a single investor over an amount of time. Changes in income level, marital status, and age can have a very tangible effect on what’s an acceptable level of risk versus what’s not acceptable. And that last one, age, is especially impactful. As you progress through your financial journey, the need for higher returns gets smaller and the need to preserve hard-earned wealth grows. Therefore, it’s highly likely that your personal optimal asset allocation will change over time, too.

Target Date Funds as a Solution (8:27)

Bo: For folks that don’t want to reevaluate their risk profile and rebalance their investments every year, something we tend to suggest are indexed target retirement funds. These funds rebalance in an attempt to match your risk profile as you progress through your financial journey. And you’ll notice that you move through many of those portfolio iterations as the portfolio rebalances. When you’re young, equity allocations are roughly in line with that 80 to 90% figure. But as retirement approaches, you’ll reach that 60/40 split and then in retirement, additional risk-off holdings are introduced and equity allocation is decreased reflecting that focus on wealth preservation rather than simply incurring unnecessary risk simply to chase more returns.

Closing (9:06)

Bo: So in short, know your personal risk profile, take compensated risk when necessary, and don’t over complicate your investment strategy by trying to find the perfect balance. If you want to know more about the ins and outs of investing, click right here. And as always, keep building towards your great big beautiful tomorrow.