Asset Allocation: Stocks versus Bonds versus Cash

Welcome to the fifteenth post of The Invested Counsel—thoughts about financial planning for young lawyers.

In the last few posts, I’ve discussed the three main parts of a young lawyer’s portfolio: stocks, bonds, and cash. For stocks and bonds, your money should be invested in a fund that holds a lot of them. Your cash should be spread out into three or four buckets (physical cash, a checking account, and either or both a high-yield savings account or a money market fund).

In this post, I’ll discuss how you should divide up your portfolio among these various buckets. This is called “asset allocation,” and it may be the most important investing decision that you make. A famous 1986 study examined the returns of various pension plans, and found that asset allocation decisions were the most significant driver of portfolio variability (i.e., over 90%). See Brinson, G. P., Randolph Hood, L., & Beebower, G. L., Determinants of Portfolio Performance, Financial Analysts Journal (1986).

The implication of this conclusion is important: it doesn’t much matter which stocks and bonds the pension funds picked, so much as that they chose to invest more in stocks or more in bonds.

While you are not a pension fund, the lesson is the same—how much you allocate to the basic buckets of stocks, bonds, and cash is extremely important.

The three buckets, and their tradeoffs.

With the three buckets of stocks, bonds, and cash, there are two main parameters to consider: how squiggly they are (i.e., how volatile they are, or how quickly they jump up and down unexpectedly), and how much you can expect them to appreciate over time. These parameters are in an inverse relationship, meaning that if one is higher, the other is lower.

(1) Stocks: very squiggly, but more opportunity for appreciation.

(2) Bonds: somewhat squiggly, some opportunity for appreciation.

(3) Cash: not squiggly, little or no opportunity for appreciation.

The technical term for this is the “risk-return tradeoff,” meaning that in order to get a higher return (i.e., for your assets to appreciate in value), you need to accept more risk (in this context, risk means volatility or squiggliness).

What goes into picking an asset allocation?

The asset allocation decision therefore comes down to how much squiggliness you can handle to get a greater chance at appreciation. But this decision is tricky, and comes down to two (other) main parameters: your capacity for risk and your risk tolerance.

Capacity for Risk. Your capacity for risk is determined by the objective factors of your circumstances that allow you to deal with volatility in the stock market. For example, if you are young, have a steady job, limited fixed expenses, and a good emergency fund, you objectively can deal well with volatility, because economically you are likely to be fine if the stock market drops.

Risk Tolerance. In contrast, your risk tolerance is your subjective, emotional capacity for dealing with the stock market. Some people are good at handling the ups and downs, and it doesn’t bother them. And some people get very nervous about the stock market dropping.

How to choose your own asset allocation.

In deciding how to arrive at the right asset allocation, you need to consider both your capacity for risk and your risk tolerance, and then pick an allocation that is right for you.

But this is difficult for at least two reasons. First, it requires an accurate sense of not only your objective financial situation, but an accurate sense of what your own subjective emotions will be about investing over the long term. To have an accurate sense of your risk tolerance, you need to be able to predict how you will feel in the future about some bad event. Not easy.

Second, even if one did have an accurate sense of your capacity for risk and your risk tolerance, it is difficult to translate that to an asset allocation. Even with just two options (stocks and bonds), there are an infinite number of ways to split your money between these two categories (0/100, 24/76, 98/2, etc.).

To make things simple, for most young lawyers, I think it is easiest to pick an asset allocation based on three guideposts:

(1) 60% stocks / 40% bonds

(2) 80% stocks / 20% bonds

(3) 100% stocks / 0% bonds

Why not less than 60% stocks? If you are a young lawyer, I think your allocation should generally be at least 60% stocks. The point of investing is to grow your wealth over the long term, and a young lawyer should have the timeline to weather a lot of squiggliness in the market. That being said, if you know that the market makes you very, very nervous, it is ok to allocate less than 60% of your long-term money to stocks . . . but I would try to increase your risk tolerance, potentially by learning more about investing. And of course, there is no better place in the world for a young lawyer to learn about investing than right here, at The Invested Counsel.

60% stocks / 40% bonds. The 60/40 allocation is the baseline asset allocation in financial planning (not just young lawyers). If you are a young lawyer and the stock market makes you nervous, then I think this is the one for you.

80% stocks / 20% bonds. I think this is probably the sweet spot for most young lawyers. By definition, young lawyers are smart, hard-working, have many decades of investing time ahead of them, and are likely to have steady, good income over that time. This allocation is fairly aggressive, but if the market goes down, the 20% in bonds will likely be more stable.

100% stocks / 0% bonds. Allocating 100% of your long-term money to stocks seems like the obvious right choice, since it is the one that is most likely to make you the most money. It is not. You should hold only stocks, and no bonds, if you are very confident that you can handle the squiggliness of the stock market. I would recommend this only if you had some real experience with significant drops in the market.

Why is that? Because you don’t want to realize you can’t handle the squiggliness of the market during the next huge downturn. That’s because you’ll panic sell when things are at their worst, and miss out on the gains that will come later. It’s better to be less aggressive, and be able to stick with your allocation.

How cash can help you invest more aggressively.

Cash is outside the stock/bond asset allocation split, because cash is for near-term money, and stocks and bonds are for long-term money. But as mentioned in the last post, cash pays a psychological dividend: it makes you feel more confident with your money. If you know that you can handle most financial demands that come at you over the course of your life, because you have a robust emergency fund, you’ll feel more confident that you can deal with volatility in the stock market. If your cash allows you to take on more risk, then that can compensate you for the growth you lose by holding a lot of cash.

That’s all for now. Have a wonderful week.

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