I’ve been having quite a few conversations about investment portfolio allocation recently. Mainly around people wanting to hold fewer bonds and have more exposure to stocks because the stock market has been on a tear, and bonds have had one of their worst decades ever.
Portfolio or asset allocation has to do with how investors divide their portfolios between different kinds of assets. The three main asset classes are equities (stocks), fixed income (bonds), and cash.
There’s no simple formula for how much of each you should hold; it depends on factors such as risk appetite, financial goals, and investment time horizon.
Each asset class has its own risk/return profile. Stocks have the highest expected long-term return but also come with the most risk and volatility. Bonds have a lower expected long-term return but can provide steady income and stabilize a portfolio. Cash has no real potential for return but comes with no risk of loss either.
The one thing to keep in mind for every investment discussion is that risk and return are forever linked. You can’t have one without the other.
So let’s go through the history of risk and return for each category.
We’ll start with cash, which can be money in a high-yield savings account, a money market fund, a CD, or anything connected to 3-month Treasury Bills. Here are the annual returns dating back to 1950:
As you can see, there are no down years for cash, but the upside is limited.
Now let’s look at bonds. I’m using 10-year Treasury returns as our stand-in. Here are the annual returns going back to 1950:
As opposed to cash, bonds have had six negative years since 2010—including three of the last five years. Rapidly rising rates with higher inflation haven’t been a good combination for government bonds in recent years.
Finally, here are the annual returns for stocks going back to 1950:
While stocks only had two more negative years compared to bonds (16 out of 76 years compared to 14), the drawdowns are much steeper than bonds.
However because risk and return are linked, stocks have also had huge upside.
Since 1950, these are the average annual figures for each category:
- Stocks: 11.2%
- Bonds: 5.6%
- Cash: 3.5%
By taking on more risk through stocks and bonds, investors were rewarded with higher returns over the past 76 years.
If you adjust those numbers to account for inflation, the real returns are as follows:
- Stocks: 8.1%
- Bonds: 2.5%
- Cash: 0.4%
The benefit of holding cash is there’s no risk of loss. The downside is it’s barely kept pace with inflation. Which is another form of risk —one, you could argue, that’s even more detrimental to building wealth in the long run.
Again, going back to our risk/return principle, given a long enough sample size, stocks will always outperform bonds, and bonds will always outperform cash.
Yet, there will be windows and shorter periods where that won’t always be the case. Since 2022, bonds have had a far lower annual return than cash:
- Bonds: -2.3%
- Cash: +4.2%
This is why some investors have recently wanted out of their bonds and to hold more money in a money market fund or a high-yield savings account.
From 2000 to 2009, both bonds and cash did better than stocks:
- Stocks: –1.0%
- Bonds: +6.5%
- Cash: +2.7%
The economy is cyclical. So as with anything, the performance of these asset classes will be cyclical too.
The lower the Federal Reserve keeps short-term rates, the lower the return for cash. The higher prevailing interest rates are, the lower the return for bonds. But perhaps the biggest risk to both is inflation.
In the long run, you do get paid for taking on more risk with stocks.
Does that mean you should only hold stocks?
No, not necessarily.
Each asset class has its purpose depending on your risk appetite, financial goals, and investment time horizon.
Thanks for reading!
Jake Elm, CFP® is a financial advisor at Dentist Advisors. Jake a graduate of Utah Valley University’s nationally ranked Personal Financial Planning program. As a financial advisor at Dentist Advisors, he provides dentists with fiduciary guidance related to investments, debt, savings, taxes, and insurance. Learn more about Jake.