Asset allocation is one of the most important decisions an investor needs to make. To determine your mix of domestic stocks, international stocks, and bonds, you need to determine your appetite for risk.
The first step of asset allocation is deciding what percentage of your money to put in stocks versus bonds. People who are more risk-averse should hold more bonds, while people who can tolerate risk and desire higher expected (but not guaranteed) returns should hold more stocks.
I have cautioned many investors, especially young investors, not to put too much money into stocks. There is a trend for younger investors to allocate more and more money into equities as the stock market has risen, and they always say that they can handle the risk. You even see people discussing ways to employ leverage to obtain greater than 100% exposure to stocks. Their reasoning will usually go something like this:
I have a high risk tolerance. Any correction or bear market would be a buying opportunity. I have a long time horizon and I know that stocks generate higher returns than bonds.
Iron Mike’s Words Of Wisdom To Investors
Mike Tyson needs no introduction. Dominating opponents in the late 1980s and early 1990s, he was one of the most feared boxers ever. With a powerful punch and high knockout rates, people would watch his fights with anticipation, knowing that a first-round knockout was always possible when Iron Mike stepped into the ring. With a mean personality, he struck fear into opponents and observers alike. Before one fight, after being told by reporters his opponent’s plans for beating him, Iron Mike delivered the famous quote:
Everybody has a plan until they get punched in the mouth. – Mike Tyson
Part of the reason why Tyson’s quote is so famous is that his words can be applied to many other areas of life, including investing. Everyone thinks they can take a lot of risk until they get hit with a big bear market. It’s hard to know whether you can handle a big bear market until you actually experience one.
Everybody’s got a plan until they get hit in the mouth. Watch what you say and who you say it to today. pic.twitter.com/DYiQO11Wpj
— Mike Tyson (@MikeTyson) July 9, 2013
Many young physicians have been investing only during this current bull market. They don’t know what it’s like to lose 50% of their portfolio value. Some physicians lost years worth of salary over the course of months during the tech bust and the financial crisis.
The Panic Of A Bear Market
You can read and understand my blog or White Coat Investor or Bogleheads, who will tell you to “stay the course”, but when you’re losing tens of thousands of dollars every day, with no end in sight, it’s hard to stay in the market.
Bear markets are never orderly. A bear market never occurs just because of “profit-taking” after a long bull market. Bear markets are as fierce as a Mike Tyson punch. During the financial crisis of 2008, people really did believe the entire global financial system could collapse and the world would plunge into a second Great Depression, or worse. Bear Stearns and Lehman Brothers, two of the premier investment banks of their time, did not survive the financial crisis.
Even Jim Cramer Panicked During The Financial Crisis
Even seasoned market investors can panic during times of market stress. After a particularly rough week in the markets, Jim Cramer, a market veteran and host of the Mad Money show, went on the Today show in October 2008 and told Ann Curry, along with the rest of America (emphasis mine):
“I thought about this all weekend. I do not want to say these things on TV. Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe that you should risk those assets in the stock market right now.” – Jim Cramer
To be fair, he did say that for people who had a longer than 5-year time horizon,
“I think what you have to do, if you can withstand it, is just ride it out” – Jim Cramer
You can tell that he didn’t even want to say what he said when he said it. “I do not want to say these things on TV,” he prefaced his quote. But it just goes to show that bear markets are very scary and it’s hard to think clearly in times of stress.
Until You’ve Experienced A Bear Market, Have At Least A Little Bit Of Bonds
Even a 10% allocation in bonds, which I use, will cushion the blow of a bear market. By giving yourself a small cushion in bonds, you can mentally tell yourself that you are not experiencing as many losses as you would have if you held 100% stocks. Psychologically, this can help you weather the storm.
A new investor who has 100% stocks can easily panic during a market crash and quickly become 100% cash. A young investor (such as a new attending physician) may experience losses that cause them to exit the market for years. After the bear market, it will take time, often after the market has recovered much of its losses, before they tread back into the market. This mistake will be magnified year after year for the rest of their lives because of the power of compound interest.
We spend a lot of time quibbling about a basis point (0.01%) here or there, but maintaining your asset allocation during a bear market will be far more critical to your long-term financial success than whether you invest in the S&P 500 or Total Stock Market.
If you make it through the next bear market unscathed, telling all your friends to be “greedy when others are fearful”, then by all means, invest aggressively after you’ve proven yourself. If a big bear market occurs early in your career, remember that the number of dollars at stake is relatively small compared to when you are nearing retirement. A bear market early in your career can be a good test of your resolve and risk tolerance.
Have A Plan, Despite What Mike Tyson Says
This is not to say you shouldn’t have a plan and just roll with the punches. You should have a plan, ideally written down in an investor policy statement, that you can turn to in times of market stress. It will bring mental clarity in troubled times, helping you to make good decisions and stay the course when everyone is exiting the market. Mike Tyson may have said that his opponents throw out their plans when they get punched in the mouth, but fighting Iron Mike without a plan is a sure recipe to get knocked out.
What do you think? How did you react during the tech crash and/or financial crisis? If you’ve never experienced a big bear market, what is your asset allocation?