How to Choose Your Stock/Bond Mix (and Stick With It When Markets Get Ugly) (EP.236)

0:29We all need to make smart decisions with our money. is building on the previous one. So if you missed the first three, they are linked in the show notes at the longterminvestor.com. But we have talked about what is the market portfolio and how should it influence how we invest. We've talked about index versus factor investing. So focused in on that stock sleeve part of the portfolio. And then last week, we talked about why your bond questions are really about cash. And I ended that conversation saying, okay, now it is time to implement and we are going to start with the biggest decision in your portfolio, which is your mix of stocks and bonds.

1:06But before we go about choosing an asset allocation, because that's really what we're talking about here, I think we need to get clear on one thing because most bad allocation decisions, I think, start with a bad definition of risk. Now, there are lots of different types of risk. And most people talking about investments will use volatility as the definition of risk, which isn't necessarily wrong, especially for true capital allocators. But for investors like you, the one I want to focus on is the risk of failing to fund your life. Your portfolio is going to go down in value. It's just something that's going to happen.

1:46And we never know when or why the next downturn will occur, but we can build a portfolio that assumes that we will experience downturns with a similar magnitude and frequency as we have in the past. And that's why I think it's more important for us to focus on that risk of failing to fund your life. And funding your life isn't just about not running out of money. I think it's about having enough to use it in ways that you won't regret later. And once you define risk that way, I think you can start to see that stock and bond decision for what it really is. It's not this moral choice, and it's certainly not a search for safety.

2:26It's really just a trade-off. Stocks carry the risk you can feel. They have those big swings, the scary headlines, and those drawdowns that test your nerves. Stocks also give you the thing that long-term investors actually need, which is the best shot at compounding your savings greater than the rate of inflation so that you can not just protect your purchasing power over the decades, but grow it. Now, bonds, they reduce that visible volatility. They steady the ride, but they don't eliminate risk. They change the kind of risk you're taking. When you own more bonds, you're often trading away the risk of that scary statement or those big drops in your portfolio for the risk of a quietly underfunded future.

3:13You're effectively paying for comfort with lower expected long-term growth. And that can show up later as one of three outcomes. Either makes you need to save more, need to work more, or spend less than you hoped. So here's my starting point. If you're a long-term investor and you can tolerate it, equities should be the default growth engine. And not because stocks are safe. I mean, they're not, but because the long-term risk of not owning enough stocks is often bigger than people admit. At the same time, I'm not here to shame bonds. Bonds definitely have a job. And for a lot of people, bonds are what keep them invested in stocks when markets get ugly.

3:53And that behavior, the ability to stick with the plan, probably matters more than finding the mathematically optimal mix. So in the rest of this episode, we'll do two things. First, we're going to decide the right mix of stocks and bonds based on your ability to take risk and your willingness to live with it. And then we're going to talk about implementation. So how to fill the stock sleeve, how to think about bonds, where cash fits, and how to rebalance without making it up as you go. So let's get started with this foundation. Choosing the right mix of stocks and bonds. This is asset allocation.

4:27It's simply that decision of how you divide your portfolio to balance the risk and return for your situation. And there is decades of evidence pointing to the same conclusion, which is that this decision explains most of the year-to-year experience you're gonna have. So the goal here isn't to find one correct allocation. The goal is to find the mix that fits you so that you stay invested through full market cycles without improvising at the worst possible time so that you can fund the life you want to live. And for that, I usually have this framework. It's a two-part test. It's your ability to take risk and your willingness to live with it.

5:07And the right allocation is basically the overlap between those two. So ability is an objective measure. It's about math and the structure of your life. It's not a personality test. The factors that matter most are time horizon. So like when are you first going to need the money and over what window will you spend it? Because the longer the runway, the more short-term volatility you can tolerate because you're giving compounding time to work. If you have a short runway, you have less capacity. Now, if part of your portfolio is intended for children, philanthropy, or a long legacy timeline, that sleeve can be invested with a longer horizon and that changes the conversation.

5:49Another measure of ability is the liquidity needs relative to the size of the portfolio. This is really a ratio, and it's basically, if your spending needs from the portfolio are small relative to your portfolio size, you have more capacity for risk. Now, if your needs are large relative to the assets, the capacity drops. And this is where the previous episode on cash management fits perfectly, because a real cash system reduces the chance of forced selling, which increases your ability to maintain a growth allocation. Human capital is another big factor of your ability to tolerate risk. Human capital is just your earning capacity.

6:26So if you're younger and you're still earning and your income is stable, you can replace market losses with future savings. So that naturally increases your capacity. If you're retired or close to retired, or if your income is cyclical or uncertain, I think you could argue that your human capital is lower and thus your capacity is lower. Now, some retirees have really strong, what I would call human capital substitutes. So these are pensions, annuity income, rental income, cash flows that act like a stabilizer. That raises the capacity compared to someone who's living solely on the portfolio withdrawals and social security.

7:04And then we have safety nets. So I've already touched on this. In the last episode, the bigger your safety net, those cash reserves, any sort of insurance or reliable income, the less likely you are to become a forced seller when markets drop. And the less likely you are to become a forced seller, the more equity risk you're able to carry in the long-term portfolio. Lastly, on the ability side, we have the flexibility of your goals. So if you can adjust spending or delay retirement or pick up income or reduce certain goals temporarily, you have more capacity to hold a growth allocation. Whereas if you're spending is rigid, like you have a ton of fixed bills and there's very little room to cut, the capacity drops.

7:49These things are all something that you can calculate in a spreadsheet. They are very objective and pretty easy, especially if you're working with somebody to identify and work through those issues. I think where things get a little trickier is on the second part, which is the willingness to tolerate risk. And so this is a little bit more psychological. Risk tolerance questionnaires were popular for a little bit, and you still see them some, but they are notoriously flawed. And your own judgment about your willingness to tolerate, not just take the risk, but to tolerate the risk, is likely to be biased as well.

8:22Instead of pretending there's a perfect questionnaire, here's the simplest test I know. I like to call it the dollar drawdown test. And at PlanCorp, we like to treat it as a final gut check before committing to an allocation. because there's a lot of things that we go through in a discovery meeting where we have training to sort of collect what we think willingness is. We're trying to pair willingness with ability to tolerate risk. And by the time we're going through an investment policy statement, we'll show somebody the worst one-year, three-year, and five-year market returns and translate those losses to your portfolio in dollar terms.

8:56And just saying, like, would you be okay sticking with this predetermined asset allocation and rebalancing plan if you lost this much money? So for example, if you have a$1 million portfolio and we see that the worst 12-month period for a given allocation was down 40%, we'd ask you, well, how would you feel if you lost$400 ,000? Now, that kind of drawdown has happened before. The Great Financial Crisis was the last time it happened. And that exact number is obviously going to vary based on your mix. But the point is the same. It's a good litmus test because in the worst situations, the optimal allocation on paper, I'm doing air quotes despite this being a podcast.

9:36The optimal allocation on paper is totally irrelevant if you're unable to hold onto it and rebalance into it when it's uncomfortable. That's how you choose the stock bond mix. The next step is choosing what goes in each sleeve, and we've spent a lot of time on this in past episodes. One clarification, and I feel like I'm really drilling this home because this was also in the last episode, is that cash belongs on your household balance sheet for near-term needs and reserves. Inside the investment portfolio, cash needs to be kept small because over long spans, cash has historically struggled to beat inflation after taxes.

10:12Your portfolio is for compounding. Cash is for stability and near-term liquidity. So let's not confuse those two. Now, when we think about how to fill the stock bucket, I'm going to assume that you're all up for starting with a global mix. Now, the research, It's a little frustrating that it isn't precise. Everybody wants a precise number, but it suggests that the diversification benefit from investing beyond the U.S. kicks in somewhere between 20 to 50 percent of an allocation to non-U.S. Now, I don't mind sharing that at PlanCorp, we use a 30 percent allocation, and I know there's a lot of different approaches to this.

10:49Some people believe in having the allocation drift alongside market weights. Some people believe in a 50-50 split. Others are an 80-20 split. In general, the most important thing is to pick a strategy and stick to it. And then once you've picked that allocation between U.S. and non-U.S. stocks, start thinking about equity strategies. And I touched on two rules-based approaches in episode 234, index versus factor investing. And rules-based is my preferred term for what I think a lot of people think of as passive, but it mostly means that you just don't predict the future. No predicting the future, low cost, super diversified.

11:26So I think you need to go back to that episode if you want to kind of hear the nuances of how I might think through that decision. And then when it comes to bonds, I am firmly in the bond fund camp. For most long-term investors, bond funds are simpler and a more reliable tool. And the cases where individual bonds make sense are much narrower than people assume. And honestly, I think anybody who's really pushing you hard to use individual bonds in a long-term portfolio either isn't familiar with the new sets of products that have come out in the past decade, or they don't really understand the research, or there's just a vested interest.

12:04There's some sort of conflict of interest there. It's just, to me, it's overwhelmingly in favor of all the evidence of using a bond fund rather than an individual bond. And when it comes to bond funds, this sometimes surprises people, but again, I'll link to some episodes in the show notes at the long-term investor. But when it comes to bond funds, I'm more hesitant to use index funds there because the bond market is so much different than the stock market, structurally speaking. Perhaps the most notable difference, I think, just being that over half of bond purchasers don't have a return maximization objective.

12:40And really think about that because when people go and buy stocks, it's to make money, but there are more than 50 % of the overall bond market are buying bonds for a reason that has nothing to do with earning a profit. So naturally, that is going to shift some things. There's also just some inefficiencies with the way that bond indexes are constructed. And so the case for indexing in stocks, which is a very good case, really doesn't apply to bond markets. It's just a totally different animal. If you want to learn more about that, I have a whole episode dedicated to it. You can find that link in the show notes at thelongterminvestor.com.

13:16Lastly, rebalancing. I haven't done an episode on rebalancing in a long time. And since I just referenced an episode that's maybe 20 months old, I'll just spend a few minutes here on rebalancing before we close out. So rebalancing brings your portfolio back to the mix of stocks and bonds you intended. And there are some periods where that can enhance return. but I think it's better to set your expectation around it as being a risk management tool. Now, I've looked hard for what would be the perfect rebalancing strategy over the years. I mean, you would not believe the number of papers, the number of spreadsheets that have been dedicated to this measure, but the simple answer and somewhat the disappointing answer is that there just isn't one without knowing what volatility and what returns are going to be in advance.

14:03Now, obviously, if we knew that, this would all be a lot easier, But the thing is, different strategies work over different time periods, depending on what the returns are daily, monthly, quarterly, annually. And so if it depends on what period you measure, we can't really know what's going to work without perfect foresight. So we're not going to have that. And to me, that means that the most important thing you can do is pick a system and stick with it forever. The two most practical systems, in my opinion, are calendar rebalancing, which is really just picking a fixed date, often quarterly or annually, and then resetting the portfolio to the target weights.

14:40The other system is threshold rebalancing, where you define tolerance bands. You might say plus or minus 5 percentage points or plus or minus 10 percentage points around major sleeves of the portfolio, and then only rebalance when the drift exceeds those tolerance bands. Now, the evidence, it's going to show you that there is not a single winner of strategy across all periods or all portfolios. But our research generally suggests that if you're going to be able to use threshold rebalancing and you're able to review that every single day, that is probably what's going to come out ahead the most.

15:15We obviously do that at PlanCorp, but I do realize that individual investors may not want to check their portfolio every single day. And also, smaller financial advisory firms can't even logistically do this because they don't have enough people to support someone to check every portfolio in their firm every single day. So I think in those cases, choosing a rule you can adhere to is going to be the next best option. And that is typically going to be some sort of calendar rebalance. Now, I appreciate you listening to this episode. Again, I referenced prior episodes quite a bit here, four episodes in a row, all of them kind of coming out of thinking through my book as we're going through the final editing stages.

15:55If you want to get some updates on my new book that will be out in 2026, you can sign up for those at theperfectportfoliobook.com. Again, that is theperfectportfoliobook.com. As always, thanks for listening. And until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit the long-term investor.com.

16:51Thank you.