The above image is a chart of the S&P 500 over the last five years.
Imagine this scenario:
You’ve worked hard for 20, 25, or 30 years. You’ve saved frugally, invested heavily in your 401k and IRA. You’re coming up on retirement and you’ve built a portfolio of $1,000,000 by October 2007.
You’ve taken some risks with your investments, but they have paid off since you started investing long ago. A majority of your portfolio is in stocks. You favor stocks for their growth potential versus the conservative relative safety of bonds.
Not ultimately worried about your investments — hey, you weathered the tech bubble, didn’t you? — you don’t make much changes to your portfolio after hearing a few things about the potential downsize of this housing bubble. It’ll be alright… we can ride this thing out.
Let’s make some simple assumptions about the portfolio… it’s mostly in the S&P 500. And by mostly I mean enough that we can just use the S&P 500′s returns to estimate the value of the portfolio.
That $1,000,000 you had saved up as of last year is now worth only $546,300 (as of time of writing the S&P is down 45.37% from last year). Completely devastating.
Hope that gives everyone some perspective on the market.
A Diversified Portfolio Survives Intact
Compare to the same portfolio with a 50% stocks (S&P 500), 50% bonds ratio. I used Vanguard’s Total Bond Index (VBMFX) as a proxy for bond returns. Vanguard’s Total Bond Market has been down only 1.61% over the last year.
If you were one year away from retirement, a 50/50 split would be pretty reasonable. And your portfolio fares much better. The same $1 million portfolio would be worth $765,100 versus $546,300 for an all stock portfolio. That’s a difference of 40% and $218,800 extra in your portfolio.
Your portfolio would still be down — 23.49% — but that is much, much better than the all stock loss of 45.37%.
Take this lesson to the bank: as you get older, move more of your assets to more conservative holdings. As you age, you have less time to recover from a serious market downturn. The safer returns of bonds help keep your portfolio where you will need it when you retire.