More stocks or bonds coming out of COVID pandemic? Depends on your comfort with risk

Amid the common talk of a “new normal” way of life and work in the post-COVID world, there is increasing discussion in the investment community regarding a new normal in terms of balanced investment strategies.

Expectations for future returns from bonds are uninspiring. This has led to suggestions that a traditional balanced investor — typically owning roughly 60 percent stocks and 40 percent bonds — needs to be willing to accept increased risk in order to pursue similar returns to the past.

Many asset managers produce return forecasts, all of questionable value given the difficulty in modeling future events and their influence on stocks and bonds. Vanguard’s most recent Capital Markets Model, for instance, identifies a median 10-year projected return for a typical 60/40 mix as 4.6 percent per year. That is about one-third less than the average of the past 20 years. The idea gaining attention is that a 70 percent stocks, 30 percent bonds portfolio should be the new standard for a balanced investor.

Of course, we can’t know what future returns will emerge, or the level of market volatility we’ll have to withstand in order to achieve those returns.

If you are considering investing new money or just shifting a current investment mix from 60/40 to 70/30, it would be helpful to understand how much return, and how much more risk, might be represented in the heavier stock mix.

Results for a collection of indexes representing U.S. and international stocks and bonds over the 20 years ended Dec. 31, 2020 show a 60 percent stocks portfolio returned 6.71 percent per year over the 20-year period. The 70 percent stocks portfolio returned 6.97 percent per year.

If you had $100,000 invested at the start of the period, that 0.26 percent 20-year average annual edge would have generated $18,280 more for the 70 percent stocks portfolio. But how much more market risk was evident in that period?

Over the full 20-year period, account balances for the hypothetical 70 percent stocks portfolio were a little more than 11 percent more volatile than the 60 percent stocks portfolio. The largest decline in value over any rolling 12-month period for the 60 percent stocks portfolio was -30.81 percent. For the 70 percent stocks portfolio, it was -33.83 percent. You could view that downside risk as a relatively minimal difference in order to position for higher returns. What we don’t know is how you’ll respond in a significant market downturn, if it occurs.

In real-time, not hindsight, there will never be the “just right” moment to invest new money or to shift your current assets to a new investment mix. No matter the starting conditions, there will always be a wide range of possible outcomes for any investment portfolio, conservative or aggressive.

When thinking about your core long-term money, you might have the capacity to increase risk and expose your accounts to a wider range of potential outcomes. Any money that you expect to need in the next couple of years, and therefore can’t afford to have exposed to a potential decline, shouldn’t have increased stock market exposure. In fact, it might not be justifiable to have any stock market exposure, even if real growth is unlikely from bonds.

Investors who have a natural inclination to position for growth and accept more volatility might not struggle with this decision. More conservative investors, who are taking relatively less risk in their investment strategy, also tend to be the most sensitive to expanding potential downside risk, even if it is only momentary.

In other words, moving from 60 percent stocks to 70 percent might be easier than, say, moving from 30 percent stocks to 40 percent stocks. Rather than take more risk, the conservative investor might prefer to reduce spending expectations to something that can be supported even if the investment portfolio performance is lower than hoped.

Your finances, your need for income and market conditions might flex meaningfully over time, causing you to re-evaluate. While you should periodically assess projected returns and the level of risk in your investments, you likely shouldn’t make significant changes to your investment strategy trying to navigate around specific market conditions.

Whether you are a conservative investor or an aggressive investor, the best portfolio for you is the one you can commit to with light modifications through a variety of market conditions. When fear and greed become more evident — whether or not you want to admit their presence in your decision making — and you make large shifts in your investment strategy, that’s when the emotional element of investing becomes detrimental and can subvert a disciplined process that is more likely to work over time.