Stock and bond allocation is critical to achieving the investment return you desire. Stocks hold greater risk with an equally great chance of return; bonds hold low risk but have a low return. Depending on your financial situation and your investment goals, stock and bond allocation can be quite different.
Modern Portfolio Theory
Modern portfolio theory originated from the 1952 paper by University of Chicago Economics Professor Henry Markowitz. Modern portfolio theory argues that a portfolio can increase returns by taking on more risk. Specifically, investing in stocks produces a higher risk as well as a higher return. Markowitz calculated risk in terms of the standard deviation of the movement of the asset. In order to achieve the best stocks and bonds allocation, you must understand the kind of risk that you are willing to take.
Efficient Frontier Curve
Modern portfolio theory gives rise to a so-called efficient frontier curve that helps investors target a return based on the amount of risk they are willing to take. The curve is a slowly upward facing arc with the risk in terms of standard deviation on the x-axis and the return in percentage terms on the y-axis. Each portfolio of stocks and bonds has a different risk and expected return profile based on historical results. Plug the returns and deviation into your spreadsheet program to graph the efficient frontier curve.
Your risk should be determined by your financial goals and financial situation. If you have a healthy income and portfolio, it makes sense to invest in more conservative investments, such as bonds. If you need to pay for college in a few years or you are relatively young, you have the flexibility to invest more of your assets in stocks. The average return from 1950 to 2011 for the S&P 500 was 12 percent for the stock market, although it was about 2 percent since 2000. Allocate your stock investments based on your required return.
One of the most important determinants of your stock and bonds allocation is your age. A simple rule of thumb is to allocate your bond percentage equal to your age. A 30 year old would place 30 percent of funds in bonds and the remainder in stocks. In this way, your investment profile starts at a very aggressive rate and becomes more conservative as you age.
Kathy Zheng is a personal financial planner. She holds a Bachelor of Arts in economics and is certified as a level 1 financial adviser.