Do you think you have the risk tolerance to invest 100% of your portfolio in equities? I had an asset allocation of 100% invested in equities for over 10 years. At this stage in my life, However, I no longer have the need or desire to have that asset allocation. That was how my portfolio was invested when I reached my first milestone of Saving $100,000 by age 30.
This is the first of a 4-post series about my asset allocation. This series on asset allocation is about my asset allocation at different points in my investing career. The series is based on where I started, what happened, where I am at now and where I will be heading based on age and risk tolerance.
My investing career began in 1997. This was a time Alan Greenspan referred to as a period of irrational exuberance. The stock market was soaring. The S&P 500 had an average return of over 15% per year from 1989 to 1999. If a person invested $100 in the Vanguard 500 Index Fund (VFINX) in 1989, it would have grown to $692 by 1999.
In 1997, I purchased my first mutual fund. My first fund was the Vanguard 500 index fund (VFINX). This was the only investment that I owned from 1997 until 2000. I would purchase at least $500 worth of this funds shares per month. Over that 3-year period, the Vanguard 500 averaged a return of nearly 20% per year.
In 2000, as the result of my savings and market returns, my portfolio was large enough to add more funds. To improve my diversification, I wanted to add small caps and international stocks to my asset allocation. I added the Vanguard Extended Market Index Fund (VEXMX). By adding the Vanguard Extended Market Index fund to my portfolio, I could replicate the total stock market because I already owned the Vanguard 500 Index Fund. The third fund that was added was the Vanguard Total International Stock Market Index Fund (VGTSX) for international exposure.
My asset allocation was:
Vanguard 500 Index Fund – 60%
Vanguard Extended Market Index Fund – 15%
Vanguard Total International Index Fund – 25%
As far as equities are concerned, my new portfolio was diversified. It contained every major publicly traded U.S. and international stock. In my mind, I was ready for the new century and another decade of 20% annual returns.
It did not take long for the economy to change for the worse. In March of 2000, the dot.com bubble burst. On September 11, 2001, New York City and Washington D.C. were attacked by terrorists. By 2003, the U.S. was fighting two wars in Afghanistan and Iraq. Those unfortunate events drove the U.S. economy into an extended recession.
As the result of those events, the stock market posted losses for three consecutive years. The average annual return on my portfolio was a loss of -16%. In other words, if you invested $100 in January or 2000, it was worth $61 by January of 2003.
How did I handle the prolonged recession and market contraction of the early 2000s? I stayed the course. I dollar cost averaged the same amount of money into my investments every month. My goal was to reach financial independence, so I rode out those volatile markets and took advantage of buying equities at a reduced price. I would, however, feel unnerved when I paid attention to the media. Fortunately, I was too busy working and going to college to become obsessed with the media. I honestly do not remember ever feeling overly fearful during this period.
My patience did ultimately pay off. By sticking with my allocation, I was rewarded handsomely between 2003 and 2007. Over the course of those next five years, my portfolio had an average return of more than 16% per year.
During my first 10 years as an investor, my portfolio returned slightly more than 8.5% per year. This asset allocation, however, was extremely volatile. The best year returned 34% and the worst year had a loss of -20%.
An asset allocation of 100% invested in stocks is not suited for every investor. It worked for me because I was young and able to dollar cost average when the market was both up and down. This type of volatility does cause many investors to sell low and buy high. That is a losing game if you want to reach financial independence. If you cannot honestly handle a -40% drop in the value your portfolio, then a portfolio made up of 100% stocks might be too aggressive for you.
There is a simple solution if the volatility of a portfolio invested in 100% stocks causes you to feel insecure. Add a percentage of bonds to your portfolio that matches your risk tolerance. In my next post, I will write about how adding bonds to my asset allocation reduced the market volatility of the next decade.
Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.