A Dynamic Stock to Bond Ratio

A dynamic stock to bond ratio helps manage the risk in your investment plan by spreading that risk out over time. That means you’re less likely to be affected adversely by the inevitable volatility of the stock market.

The ratio of bonds in your investment plan should be inversely proportional to the diminishing time horizon for each of your financial goals. The shorter your time horizon for investment, the bigger the bond component should be (and the smaller the stock ratio).

Bonds represent the more benign portion of your investment plan. Although some bond investments are risky, this asset class is generally less volatile than stocks.

goal's target date  –  current age = time horizon for investment

Where to start?

What stock to bond ratio you start with is dictated by your risk tolerance. It's important to set your stock to bond ratio correctly so you won't change it because of a big downward correction in the stock market.

For longer term goals, these downward corrections are inevitable. Your investing success depends upon you sticking with your ratio through thick and thin. That means embracing these inevitable downturns and realizing they are an important part of the plan.

More conservative investors have to be careful to set their ratio aggressively enough (more stock) so that the investment plan's return at the very least keeps pace with inflation. If your return year after year falls below the rate of inflation, you're losing money. Not in the literal sense, but figuratively in that those dollars will buy less in the future than today.

Inflation example: Given 5% per year inflation over the next 20 years, you'd need $265,000 to buy the same goods and services you could buy today with $100,000.

What did you do in 2008?

Let’s look to your retirement plan, history, and the stock market debacle of 2008 for guidance in setting your initial stock to bond ratio for retirement.

Sans a crystal ball and the ability to time the market, your best move back then was to stick with your stock to bond ratio. The money you lost – roughly 35%-50% on the stock side of things – would have been recouped and then some to date.

More importantly, those contributions you were making during those down times would have bought stock at bargain basement prices and added greatly to your rate of return to date.

That’s the way it has worked so far. The stock market, which follows the boom and bust cycle of the economy, goes up, down, and repeats. Sometimes the stock market takes longer to recover than others. This last time it took around 4 years. History shows us sometimes the market recovers more quickly and sometimes it takes longer.

So, are you going to leave that ratio alone and continue to follow it, or are you going to bail on it the next time the going gets tough? If you’re likely to bail, consider making your stock to bond ratio more bond heavy. That way, you’ll be more apt to stick to the plan the next time we have a market downturn.

If you don't know what your ratio of stocks to bonds were back in 2008, that means you didn't have a plan. Generally, any plan is better than no plan, so pick a ratio and get going!

Dynamic stock to bond ratio means less stock tomorrow

Whether you start with an ultra aggressive, ultra conservative, or somewhere in-between ratio, you want it to be dynamic, meaning it gets more conservative as you move closer to your goal’s fruition date. By gradually reducing your ratio yearly rather than all at once, you’re less likely to fall prey to a steep stock market correction at the wrong time.

It’s your time horizon for investment, risk tolerance, and type of goal that dictates your stock to bond ratio both now and in the future. That’s why ratios can vary greatly from investor to investor.

Let’s first look at a retirement planning example.

The following allocations assume a retirement age of 65-67 and represent my upper and lower limits for stock to bond ratios.

Most likely your ideal ratios will fall somewhere in-between these limits

Retirement planning example

age

ultra

conservative

ultra

aggressive

stock%

bond%

stock%

bond %

age 21

75

25

100

0

age 22

75

25

100

0

age 23

75

25

100

0

age 24

75

25

100

0

age 25

75

25

100

0

age 26

74

26

100

0

age 27

73

27

100

0

age 28

72

28

100

0

age 29

71

29

100

0

age 30

70

30

100

0

age 31

69

31

100

0

age 32

68

32

100

0

age 33

67

33

100

0

age 34

66

34

100

0

age 35

65

35

100

0

age 36

64

36

100

0

age 37

63

37

100

0

age 38

62

38

100

0

age 39

61

39

100

0

age 40

60

40

100

0

age 41

59

41

99

1

age 42

58

42

98

2

age 43

57

43

97

3

age 44

56

44

96

4

age 45

55

45

95

5

age 46

54

46

94

6

age 47

53

47

93

7

age 48

52

48

92

8

age 49

51

49

91

9

age 50

50

50

90

10

age 51

48

52

88

12

age 52

46

54

86

14

age 53

44

56

84

16

age 54

42

58

82

18

age 55

40

60

80

20

age 56

38

62

78

22

age 57

36

64

76

24

age 58

34

66

74

26

age 59

32

68

72

28

age 60

30

70

70

30

age 61

28

72

68

32

age 62

26

74

66

34

age 63

24

76

64

36

age 64

22

78

62

38

age 65

20

80

60

40

age 66

18

82

58

42

age 67

16

84

56

44

age 68

14

86

54

46

age 69

12

88

52

48

age 70

10

90

50

50

age 71

8

92

48

52

age 72

6

94

46

54

age 73

4

96

44

56

age 74

2

98

42

58

age 75

0

100

40

60

age 76

0

100

38

62

age 77

0

100

36

64

age 78

0

100

34

66

age 79

0

100

32

68

age 80

0

100

30

70

age 81

0

100

28

72

age 82

0

100

26

74

age 83

0

100

24

76

age 84

0

100

22

78

age 85

0

100

20

80

Each investor is taking on risk, but at different levels. Our ultra conservative investor hopes these dynamic ratios aren’t too conservative and that their rate of return keeps up with inflation.

Our ultra aggressive investor hopes they’ll have sufficient bond resources if a protracted downward stock market corresponds with their retirement date, and that the stock market behaves like it has in the past.

A college savings example

Let's look at another financial goalsaving for your kid’s college education. Because most of the money will be spent in just a few years [versus 20 plus (?) in retirement], the ratios need to be adjusted.

child's age

ultra

conservative

ultra

aggressive

0

50

50

100

0

1

48

52

100

0

2

46

54

100

0

3

44

56

100

0

4

42

58

100

0

5

40

60

100

0

6

38

62

90

10

7

36

64

85

15

8

34

66

80

20

9

32

68

75

25

10

30

70

70

30

11

26

74

65

35

12

22

78

60

40

13

18

82

55

45

14

14

86

50

50

15

10

90

45

55

16

6

94

40

60

17

2

98

35

65

18

0

100

30

70

19

0

100

25

75

20+

0

100

20

80

Notice how both aggressive and conservative portfolios end up with very little stock by the time the kids are seniors in high school. Even aggressive investors can’t afford to gamble their kids' college savings on the volatility of the stock market over a period of just a few years.

Maintain a dynamic stock to bond ratio

Increasing your bond ratio over time makes sense. You never want to be forced to sell an investment at a bargain basement price, nor have the volatility of the stock market dictate your goal’s eventual completion date.

History has shown that the stock market can take a precipitous drop at the most inopportune time when just a few years of investing time is involved. Best to maintain a dynamic stock to bond ratio for all of your investment plans, whether it be for retirement, your kid’s college education, or one of your other financial goals.