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Financial Fundamentals

How to Choose the Right Portfolio Allocation Model

Alexandra Ardelean

Hey everyone, Marco here from Whiteboard Finance. Today we're going to be talking about portfolio allocation models. This is a topic that I've covered in the past, but I wanted to revisit it because I think it's very important for people to understand how to allocate their portfolios based on their goals and risk tolerance.

So, let's get into it.

Vanguard did a study on allocation models using specific indices. The U.S. stock market returns are based on the Standard and Poor's 90 from 1926 to 1957, and then the S&P 500. The bond market returns are based on the S&P High Grade Corporate Index from 1926 to 1968, then the Solomon High Grade Index from 1969 to 1972, and finally the Barclays U.S. Long Credit AA Index. The U.S. short-term reserves returns are based on the Botson U.S. 30-Day Treasury Bill Index from 1926 to 1977, and then the FTSE 3-Month U.S. Treasury Bill Index.

Portfolio allocation models are guidelines for goals-based investment strategies. There is no right or wrong model; it depends on individual goals and risk tolerance. Different life stages and financial goals influence investment strategies.

An income portfolio is for lower risk, older individuals with a short to mid-range investment time horizon.

  • A portfolio with 100% bonds has an average annual return of about 6.3% from 1926 to 2021.

  • A portfolio with a split of about 20% stocks and 80% bonds has an average annual return of about 7.5%, with its best year at about +40.7% in one year, its worst year at about -10.1%, over the same period.

  • A portfolio with a split of about30% stocks and70% bonds has an average annual return of about8.1%, best year at about +38.3%, worst year at about -14.2%, over the same period.

A balanced portfolio typically consists of a 60-40 split between stocks and bonds, aiming to reduce volatility.

  • A portfolio with a split of about40% stocks and60% bonds has an average annual return of about8.7%, best year at about +35.9%, worst year at about -18.4%, over the same period.

  • A portfolio with a split of about50% stocks and50% bonds has an average annual return of about9.3%, best year at about +33.5%, worst year at about -22.5%, over the same period.

A traditional financial advisor might recommend a balanced portfolio using the "120 rule" (subtracting age from 120 to determine equity allocation).

  • A portfolio with a traditional balanced allocation (60% stocks, 40% bonds) has historically returned an average annual return of about9.9%, with its best year at around +36.7% in1933, its worst year at around -26.6% in1931, over the same period.

A growth portfolio consists mostly of stocks for long-term appreciation, suitable for those with high risk tolerance and long-term investment horizons.

  • A portfolio with a split of about70% stocks and30% bonds has an average annual return of about10.5%, best year at about +41.1%, worst year at about -30%, over the same period.

  • A portfolio with a split of about80% stocks and20% bonds has an average annual return of about11.1%, best year at about +45.4%, worst year at about -34.9%, over the same period.

A high-risk, high-reward strategy is investing in a portfolio consisting entirely (100%) of stocks, which historically has returned an average annual return of about12.3%, with its best year at about +54.2% in one year, its worst year at about -43.1%, over the same period.

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In conclusion, investors are compensated for risk in their portfolios based on historical performance data.

If you were given $1 million to invest for fifteen years which portfolio would you choose?

Have a prosperous day!