100% stock portfolio for young people... why bother diversifying at all?

[sweeps]

I'm seeing several posts that advocate going 100% stocks if you're young. The reasoning is you have a very long time to ride out the bumps of the stock market, and over the long term stocks easily beat all other asset classes. All that is fine...

But if that is the reasoning, why stop there. Small-cap stocks beat large-cap stocks over the long term. Why not, if you're young, go 100% small-cap stocks? Or better yet, why not go 100% emerging markets stocks? If you have 40 years to ride out the bumps, you're going to come out way ahead. So why diversify your stock funds?

[jIM_Ohio]

Time reduces away volatility more than any other single variable. In 30 years, I don't care what my day to day balance in my account was this week. However if I do need some of that money next year, then the volatility of my account this week and next does have some impact on whether I have access to that money next year.

So yes 100% equities has some risk to it. But if one diversifies within 100% equities into at least

Large Caps
Small Caps
International Stocks

then there is improved returns (10% long term, IMO) without the risk of having all in a single asset class. There are 3-5 year periods where any one of those classes will lag, so I suggest having more than one asset class in any equity portfolio. If you only own one asset class you will possibly be chasing returns, or miss out on certain trends (extended periods of small cap outperformance, or extended periods where large caps do little).

There is a "mid cap effect" which some people believe does not exist (much financial literature does not even discuss mid caps as an asset class). There is emerging markets and international small caps to consider as well.

I construct my porfolio so the dollar gain, on average, from the pieces I include is "equal" based on risks I am willing to take.

For example, assume a $10k porfolio,
75% ($7500) in domestic equity, expect close to 10% return. ($720)
25% ($2500) in international, expect between 10 and 15% return ($380)

45% ($4500) in large cap domestic
15% ($1500) in mid cap domestic
15% ($1500) in small cap domestic
15% ($1500) in large cap international
10% ($1000) in small cap international

expected normal/long term returns:
large cap domestic 8% (8% of 4500=$360)
mid cap domestic 12% (12% of 1500=$180)
small cap domestic 12% (12% of 1500=$180)
large cap international 12% (12% of 1500=$180)
small cap/emerging markets international 20% (20% of 1000=$200)

if you look at this, 1/3 the position gets 50% the dollar value based on my expectations... in case of small cap/emerging markets, 25% the position gives more than 50% the return of the portfolio core.

Each of the smaller positions is clearly more risky (emerging markets can stay low/down for years at a time, small caps can fall more than large caps), so I construct my porfolio with a core (domestic large cap) and an explore portion (everything else).

I am getting to point where my explore position is large enough (10k positions in most right now) where the explore is divided into diversified and concentrated. Diversified will make up 2/3 of position, with a concentrated fund making up 1/3 of position. Similar goal- the diversified positions give a baseline, where as contrentrated funds are a fund manager on a hot streak.

[jIM_Ohio]

One other issue to consider is what yearly returns does it take to get a certain long term return.

10%+10%+7%+13% is not a 10% "average" return because of compounding. (It is 11.5% annualized, I believe).

So for example emerging market returns might look like

5% 5% -10% -10% +50% which is 6.8% annualized returns. The 50% is the home run which makes it almost worth it. The volatility though for 100% of a portfolio in this single asset class would be too much for most to stomach. Too much for me anyway. I invest in this class to try to get home run, but I need to accept strike outs quite a bit too- lots of risks- like if dollar gets stronger those 15% returns we all see in each international fund we own might become the 5% returns I posted above... these are cycles investors need to have time to weather themselves through.

[sweeps]

However if I do need some of that money next year, then the volatility of my account this week and next does have some impact on whether I have access to that money next year.

This is a valid concern... but then why not let Joe Investor hold 10-20% in bonds for this exact reason?

If we stick to the original premise that this is retirement money and the young investor will not be touching the money for 30-40 years, then why should he diversify? If emerging markets funds return 12% a year over the long term and S&P 500 funds return 10% over the long term, why invest ANY money in an S&P 500 fund?

(I'm using the emerging markets fund as an example only. Given a set of asset classes... I'm suggesting picking the one -- whichever it is -- that has the greatest long term annualized return.)

[jIM_Ohio]

This is a valid concern... but then why not let Joe Investor hold 10-20% in bonds for this exact reason?

I guess the part I left off was the timeframe.

If you don't need money for at least 20 years, then 100% equities makes sense. If money might be withdrawn within 20 years (or next year) then bonds should be used to mitigate volatility. Volatility during withdraw will hurt porfolio survivability more than most other factors (a high return mitigates this, but other than that, volatility will destroy porfolio in withdraw mode).

When withdrawing money, I read a study yesterday which suggested 7 asset classes for a portfolio in withdrawal mode. I did not agree with how the portfolio was constructed, but here is the link:

The Benefits of Low Correlation - Journal of Indexes

[sweeps]

Maybe put another way...

What is magical about being, say, 30% large cap, 20% mid cap, 20% small cap, 20% international, 10% emerging? Why does a young person who takes on 20% bonds too conservative? Or if he goes 50% large cap, 50% international he is being reckless?

Just in an unconventional wisdom mood today.

[sweeps]

Also I'm anticipating a comment such as "Past results do not predict future performance. Just because small caps have beat large caps for the last 40 years doesn't mean they will for the next 40 years."

This is very true... But if that is the case, again I would ask why are we excluding bonds. Bonds could outperform stocks in the next 40 years. In fact I would expect TOTAL diversification for that reason: Global stocks, global bonds, global currency, global real estate, hard assets, precious metals, etc. etc.

[jIM_Ohio]

If we stick to the original premise that this is retirement money and the young investor will not be touching the money for 30-40 years, then why should he diversify? If emerging markets funds return 12% a year over the long term and S&P 500 funds return 10% over the long term, why invest ANY money in an S&P 500 fund?

(I'm using the emerging markets fund as an example only. Given a set of asset classes... I'm suggesting picking the one -- whichever it is -- that has the greatest long term annualized return.)

Predicatibility that a person will get to where they want to go. The lower returning assets have less risk, so they have a lower corresponding return. But the stability and predicatability of that asset class is a larger known factor.

Long term =30 years. In many many cases it takes years of highs and lows to get to that average.

I believe S&P 500 return is 9-10% long term, maybe a low of -25%, a high of 50% and most years between -12% and +12%
I believe small cap is 11% long term, maybe a low of -40% and high of +60%, with most years between -20% and +20%.
I believe small cap value is 12% long term, maybe a low of -40% and high of +60%, with most years between -20% and +20%.

To get the extra 1% of return, there is more risk associated with that 1% of incremental returns. Risk in this case is market risk and deviation of returns- small companies go out of business more, get bought out more, and have management change more than larger companies. In my case, large companies also pay out a dividend which many small companies cannot afford- and that dividend is what I believe will trigger stable long term returns.

The small company universe is so complex many of the small company indices have different returns (Russell 2000 vs Wilshire 4500, for example) because the number of companies to choose from in small cap universe is much much higher. So predicatability you picked the right index or right stock or right fund is much much lower.

Add to this that the DJIA and S&P 500 are different indices, yet track to each other quite closely, large caps provide stability.

So when constructing a portfolio you want stability to a degree, as a means to achive a goal. A person slightly behind in saving could compensate by adding more risk (like a 25% stake in emerging markets) and hope they hit a home run and then cash out. People with more time might try a more conventional approach and take on less market risk and less geo political risk to let them sleep at night.

If you are worried about losing your money, you need an asset allocation which suits you... do not let someone else's allocation be what guides your decision making.

[jIM_Ohio]

Maybe put another way...

What is magical about being, say, 30% large cap, 20% mid cap, 20% small cap, 20% international, 10% emerging? Why does a young person who takes on 20% bonds too conservative? Or if he goes 50% large cap, 50% international he is being reckless?

Just in an unconventional wisdom mood today.

The person choosing the allocation must be comfortable with it. My advice on the first is it looks good. My advice on the second is what about small caps or a stonger dollar?- a strong dollar could wipe out most of the international returns!

[sweeps]

If you are worried about losing your money, you need an asset allocation which suits you... do not let someone else's allocation be what guides your decision making.

Bingo... we have a winner.

[jIM_Ohio]

Also I'm anticipating a comment such as "Past results do not predict future performance. Just because small caps have beat large caps for the last 40 years doesn't mean they will for the next 40 years."

This is very true... But if that is the case, again I would ask why are we excluding bonds. Bonds could outperform stocks in the next 40 years. In fact I would expect TOTAL diversification for that reason: Global stocks, global bonds, global currency, global real estate, hard assets, precious metals, etc. etc.

It's also about how risk is measured.

I take a certain amount of risk to get 10% returns of large caps.

To get the 11% returns of small caps, that is 1% higher than large caps
but the volatility (variability of returns) goes up considerably higher just to get that extra 1%. Small cap funds I owned in 1999 had 100%+ returns. My large cap only had 50% that year. In 2000 those small cap funds dropped 50%. The large cap funds I owned only dropped 20% or so.

Bonds have a finite return- I think the highest I have seen a reputable DOMESTIC bond fund return is 12%, and that was in 80's when bonds had a 3 year run which was quite good. And the 6% long term return of bonds is more predicatable (based on the past) than the 10% return of large caps.

The more reliable, the less risk, the less risk, the lower the return. Basic economics.

While accumulating assets, return is king- IMO the goal for me now is to maximize return.
While drawing down assets, reducing volatility over medium term is king- making sure money grows, but making sure money is not lost is also important. In this case the goal of broad diversification helps the goal of not losing money (the probability 7 asset classes not correllated to each other goes down at same time is highly unlikely).

[cptacek]

One thing, though. If you are investing in your 401(k), you SAY that you won't touch that money until you retire. But, unless you stay at that job for 40 years, you will eventually roll that money out of the 401(k) and put it in an IRA. So, you are not REALLY investing that money for 40 years, you are investing until you leave your job. Then you have to cash out and cash back in again (you don't HAVE to roll it over, but most people do, and most of us suggest to people to do that). The argument of "riding it out" only works if you own the stocks/bonds/mutual funds that could come back up again and make you money.

[humandraydel]

I'll play devil's advocate.

A young person who owns a house (with a mortgage) has two reasons to go 100% stocks:

A mortgage is like a reverse TIPS bond (or something like that!) - that is, it pays off in inflation. The payment stays the same for 30 years, yet that payment is worth less and less current dollars.

A salary is like a bond - it provides a fixed stream of income for years. Often, it rises at least as fast as inflation. If you were to amoritize this, it would be one HUGE bond!

I say, invest in stocks, let your mortgage and salary be your bonds! Bonds are for old people!

Tongue in cheek, sort of.

[jIM_Ohio]

One thing, though. If you are investing in your 401(k), you SAY that you won't touch that money until you retire. But, unless you stay at that job for 40 years, you will eventually roll that money out of the 401(k) and put it in an IRA. So, you are not REALLY investing that money for 40 years, you are investing until you leave your job. Then you have to cash out and cash back in again (you don't HAVE to roll it over, but most people do, and most of us suggest to people to do that). The argument of "riding it out" only works if you own the stocks/bonds/mutual funds that could come back up again and make you money.

asset allocation is clearly an art.

In my case, my IRA is the CORE of my investments- it must have the entire puzzle at any given time, in the correct percentages.

At beginning of 2007, my IRA was maybe 25% of my portfolio.
One rollover later (a few weeks ago) and my IRA is now 66% of my portfolio. Choosing the funds was easy, as they were already selected... outside of choosing a new mid cap (old one was closed and bloated) and a new small cap (more diversified and smaller) the decision was quite easy for fund selection.

My 401k and wife's 401k have changed 8 times in 10 years combined. In my case because of mergers and buyouts, in her case because of job changes. The 401k is a similar asset allocation for that moment in time, but in some cases a 401k is missing a mid cap, or missing an emerging markets fund, and in those cases we make logical decisions (like allocation the 15% mid cap to an index fund or small cap fund, like allocation the 10% emerging markets position to a broad international fund position).

You asset allocation should reflect your risk tolerance for that given year, regardless if you plan to roll it over 5 yeas from now, next month or next year. 12 months ago I thought my 401k was what it was for next 20 years... getting the chance to roll it over before leaving because of a buyout was a bonus.

Consider the IRA the core- make sure it has the best funds possible in it. Roll 401ks in as needed, but the fund selection won't change much, just the amounts in each fund. If you choose good funds, you won't have to dump them at each turn of life events.

I also invest close to 16k per year between both 401ks and both IRAs for wife and me... so it's easy to sizable chunks to allocate in all accounts within a short period of time.

If you invest less, I can see reasons for keeping the whole portfolio as one core and allocating accordingly. Each job change will then require an evaluation and a possible rebalance. Keep this in mind as life deals you changes.

[jIM_Ohio]

I'll play devil's advocate.

A young person who owns a house (with a mortgage) has two reasons to go 100% stocks:

A mortgage is like a reverse TIPS bond (or something like that!) - that is, it pays off in inflation. The payment stays the same for 30 years, yet that payment is worth less and less current dollars.

A salary is like a bond - it provides a fixed stream of income for years. Often, it rises at least as fast as inflation. If you were to amoritize this, it would be one HUGE bond!

I say, invest in stocks, let your mortgage and salary be your bonds! Bonds are for old people!

Tongue in cheek, sort of.

I have heard this before, and I agree.

Also consider SS to be an annuity which does not adjust for inflation. One more reason to be 100% equities.
If you have a pension, that can be considered a bond of sorts, one more reason to be 100% equities.
I have heard with unexpected monies (like inheritances) to be aggressive with these as well, as that money should not be used for long range plans.