Equities

Holding the Right Mix of Stocks

September 15, 2017
How equities can play an important role in a long-term portfolio.

Key Points

  • Markets may reward investors who take a long-term view.
  • The longer your time horizon, the more prominent a role stocks can play.
  • Diversifying your portfolio can help you manage market risk.

Equities are the main driver of a long-term portfolio’s growth. While they might underperform other asset classes in any given year, they have the greatest potential to outperform over longer periods. Why? Equities allow investors to share in the economy’s long-term growth potential, and they also carry a “risk premium”—like other riskier assets, stocks offer higher long-term returns to investors willing to endure some volatility.

In fact, equity performance has surpassed fixed income and cash in all but one 20-year time period since the mid-1920s (when comparing large-cap stocks with intermediate-term government bonds and U.S. Treasury bills, according to the Morningstar Ibbotson 2016 SBBI Classic Yearbook). Of course, past performance cannot guarantee future results, but it may help inform investment decisions going forward.

LOOKING BACK

The U.S. stock market, represented by the large-cap S&P 500 Index, has continued to provide substantial returns since the global financial crisis in 2008. As has always been the case, however, the path of the market’s advance has not been entirely smooth. Indeed, the market has suffered a few corrections—defined as a price decline of at least 10%. Small-cap stocks have even seen a bear market—or a decline of over 20%. However, all of the pullbacks to date have been temporary; in the case of a correction in 2016, it took less than two months for the S&P 500 Index to recover from its decline.

Investors who respond to volatility by decreasing their equity allocations for fear of losing money could be putting themselves at greater risk of running out of money in retirement. Moreover, if they sell just after a stock declines, they could be “buying high and selling low,” getting relatively little for the stocks they are selling, while missing the chance to make new investments at attractive prices.

Investing risks

Investors must find a balance among the varied risks they face as they develop their investment plan. These risks include, but may not be limited to, the following:

  • Market risk is the potential that your portfolio’s value will drop due to a correction or other short-term market decline. An appropriate asset allocation—the mix of stocks and bonds in your portfolio—can help manage your portfolio’s market risk.
  • Longevity risk represents the good fortune that you will live a long time and, thus, outlive the assets you have invested for your long-term savings goals. Maintaining sufficient exposure to equities in your portfolio can help support decades' worth of withdrawals in retirement.
  • Inflation risk is the corrosive impact that inflation has on your retirement dollar’s purchasing power. Low-risk bonds and cash are more at risk from not keeping up with the effects of inflation, which has averaged nearly 3.1% between 1928 and 2016, as represented by the I.A. SBBI U.S. Inflation Index.

While balancing all three risks takes work, keeping longevity and inflation in mind when making investment decisions can be the most challenging. The impact of those risks often is felt over the course of decades, while the effects of market risk can be observed over a matter of days or hours. Stocks’ volatility often drives headlines that can push nervous investors toward less volatile assets, such as bonds. For example, the worst one-year loss for equities, 1931, was nearly nine times worse than the worst one-year loss for intermediate government bonds, 1994. Yet over the past nine decades, stocks have averaged annual returns more than double those of bonds. (See “A Historical Look at Equities.”)

Where some might see only risk in stock volatility, others recognize opportunity—the chance to “buy low and sell high.” Investing in equities during market downturns offers the chance to buy more shares when prices are lower. This strategy means investors can buy more shares for a lower cost, which can set them up to benefit from the next cycle of market growth. Investors still making contributions to their retirement accounts have a real opportunity to buy stocks at a discount relative to where they were prior to a correction.

A Historical Look at Equities

From 1928 (the year before the Wall Street crash) through 2016, stocks posted some large short-term losses and gains. Over the long term, however, they not only averaged higher annual returns than both bonds and cash, but they also significantly outpaced inflation.

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Source: Morningstar Ibbotson 2016 SBBI Classic Yearbook. Stocks are represented by returns of the S&P 500 Index, bonds by returns on 10-year U.S. Treasury bonds, cash by returns on 30-day Treasury bills, and inflation by returns of the I.A. SBBI U.S. Inflation Index.

Finding a balance in your allocation

An appropriate mix of stocks and bonds can help mitigate the effects of volatility on a portfolio. The precise definition of "appropriate" will depend on your time horizon and risk tolerance, and that definition will change as you get closer to your goal. However, equities could remain a significant portion of your allocation even after you retire.

Younger investors have more time to recover from short-term market corrections and may want to focus more on longevity and inflation risks given their longer time horizon. As a result, stocks may play an important role in their portfolios.

Older investors have a shorter time horizon. Given their need to periodically cash in a portion of their investments to finance their retirement, they are less able to recover from short-term downturns. In fact, older investors with tax-sheltered retirement accounts, such as an IRA, may have to take out a required minimum distribution (RMD) each year, no matter the market environment.

But with decades of retirement potentially ahead, investors still should factor longevity and inflation risks into their investment strategy. Keep in mind that life spans are increasing for many individuals, and the chance that one spouse may live into their 90s is growing. For this reason, retirees also should consider including a meaningful exposure to stocks in their retirement portfolios, albeit with a smaller allocation than for younger investors. (See "Using Age as a Guide.”)

USING AGE AS A GUIDE

It is important to have an appropriate mix of the different investment categories: equities, fixed income, and short-term investments. The length of time a retirement investor plans to invest his or her savings can help determine how much money to allocate to each type of investment.

As an investor gets closer to retirement, his or her portfolio may move gradually from more aggressive (more equity) to more conservative (less equity). Consider the T. Rowe Price age-based asset allocation models below:

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These allocations are age-based only and do not take risk tolerance into account. Our asset allocation models are designed to meet the needs of a hypothetical investor with an assumed retirement age of 65 and a withdrawal horizon of 30 years.

The model asset allocations are based upon analysis that seeks to balance long‐term return potential with anticipated short‐term volatility. The model reflects our view of appropriate levels of trade-off between potential return and short‐term volatility for investors of certain ages or time frames. The longer the time frame for investing, the higher the allocation is to stocks (and the higher the volatility) versus bonds or cash.

Limitations
While the asset allocation models have been designed with reasonable assumptions and methods, the chart provides models based on the needs of hypothetical investors only and has certain limitations:

  • The models do not take into account individual circumstances or preferences and/or may not align with your accumulation time frame, withdrawal horizon, or view of the appropriate levels of trade-off between potential return and short‐term volatility.
  • Investing consistent with a model allocation does not protect against losses or guarantee future results.

Please be sure to take other assets, income, and investments into consideration when evaluating model allocations. Other T. Rowe Price educational tools or advice services use different assumptions and methods and may yield different outcomes.

The benefits of diversification

Adding equities to a portfolio will inevitably increase its exposure to market risk, along with other types of risk, such as company and sector risks. Holding a well-diversified equity portfolio, which means investing in a broad range of equity investments (including different sectors of the market, different regions, and different company sizes), can help manage some of these other risks.

By investing in different sectors of the economy, for instance, you help protect your portfolio against a sector-specific downturn—such as the bursting of the technology bubble in 2000. Investing in different regions, including both domestic and international stocks, gives your portfolio exposure to whatever parts of the global economy are generating the most growth at any given time. By holding companies of different sizes, you can balance the higher growth potential of smaller companies with the greater stability of large-cap companies.

Diversification cannot assure a profit or protect against loss in a declining market, but it can help smooth out a portfolio’s ups and downs. Moreover, rebalancing your portfolio on a regular basis allows you to capture the gains from outperforming investments while keeping your portfolio from straying too far from your target allocation and diversification level.

ADHERE TO A PLAN

No matter your age, your investing time horizon for retirement likely is longer than you realize. By selecting an appropriate allocation for your financial goals, properly diversifying your equity investments, and regularly rebalancing your overall portfolio, you can help give your retirement savings the best chance of successfully supporting you through what are hopefully many decades of retirement.

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