Stocks have slumped this year, with the S&P 500 dropping 21% so far amid soaring interest rates and sluggish economic growth.
The market could easily fall further as the Federal Reserve continues to raise interest rates to combat inflation.
So what’s an investor to do?
Keep two basic factors in mind: your age and your risk tolerance. For people under 30 or 40, a strong case for devoting 80% to 100% of your portfolio to stocks can be made. That’s because they outperform bonds over the long term.
Including dividends, the S&P 500 returned an annualized 10.2% from 1926 through 2019, according to Moneychimp. Meanwhile, bonds posted an average annual return of 5.3% during that period, according to Vanguard.
Stocks for the Young, and Older
Younger people should be able to ride out any drop in stocks. To be sure, there have been extended periods when stocks didn’t rise – from 1929 to 1954 and 1966 to 1982, for example. But these are very rare.
The risk of an extended decline is more serious for older people. If you’re retiring 10 years from now and plan to finance your spending through stock sales, an extended decline by equities could crimp your retirement lifestyle.
The rule of thumb is that investors should have 60% of their holdings in stocks and 40% in bonds. Just as younger people can benefit from going above 60% in stocks, older investors can benefit from going below that threshold.
Still, to benefit from equities’ historically superior returns, older people should consider keeping at least some of their money in stocks..
Those who are extremely wealthy don’t have to take the risk of investing in stocks because they don’t need to grow their wealth (unless they’re living beyond their means).
Risk tolerance also is important in deciding how much of your money to put in stocks and how much in bonds.
The more risk you are willing to take, the more money you should devote to stocks. If you’re older, you should probably exercise some caution.
You probably shouldn’t change your asset allocation in response to short-term market moves. When stocks are declining, as they are now, you might be tempted to lower your stock weighting.
But the market will do that for you. If you’re holding safe bonds until maturity and stocks fall, your stock allocation effectively drops along with the price of your stocks.
An argument can be made to increase your allocation to stocks when the market falls because you’ll be picking them up for lower prices than you could have previously.
In the end, many of you will likely do best if you don’t make any changes in your portfolios in response to the Fed’s interest rate hikes and their negative impact on stocks. Staying the course is often the best course.