Asset allocation explains over 90% of your portfolio's variance. Stock picking and market timing are statistical noise compared to your bond/equity split.
Equities vs Bonds
Equities (stocks) are ownership stakes in companies. They provide the growth engine necessary to outpace inflation. Over 20+ year periods, equities have historically never lost money in real terms, but in the short term, they can easily drop 50% (as seen in 2008).
Bonds are loans to governments or corporations. They pay a fixed interest rate and return the principal at maturity. They are the shock absorbers. When equities crash, high-quality government bonds typically rise or stay stable as investors flee to safety.
Rule of Thumb: The 110 Rule
Subtract your age from 110. That is the percentage you should hold in equities. If you are 30: 110 - 30 = 80% equities, 20% bonds. As you age, your risk capacity decreases.
| Portfolio (Equity/Bond) | Historical Return | Worst Year |
|---|---|---|
| 100 / 0 | ~9.8% | -43.1% |
| 80 / 20 | ~9.2% | -34.9% |
| 60 / 40 | ~8.3% | -26.6% |