Stocks have fallen this year, with the S&P 500 down 21% so far amid rising interest rates and slowing economic growth.
The market could fall more easily as the Federal Reserve continues to raise interest rates to combat inflation.
So what should an investor do?
Keep two key factors in mind: your age and risk tolerance. For people under the age of 30 or 40, a strong argument can be made for allocating 80% to 100% of your portfolio to stocks. This is because they outperform bonds over the long term.
Including dividends, the S&P 500 returned 10.2% annually from 1926 through 2019, according to Moneychimp. Meanwhile, the bonds posted an average annual return of 5.3% over that period, according to Vanguard.
Stock for young and old
Younger people should be able to weather any decline in stocks. Sure, there have been extended periods when stocks haven’t gone up—from 1929 to 1954 and from 1966 to 1982, for example. But this is very rare.
The risk of prolonged deterioration is more serious for older adults. If you’re going to retire 10 years from now and plan to fund your spending through stock sales, an extended decline in stocks could hamper your retirement lifestyle.
The general rule is that investors should own 60% of their holdings in stocks and 40% in bonds. Just as young people can benefit from exceeding 60% in stocks, older investors can benefit from exceeding this limit.
However, to take advantage of historically superior stock returns, seniors should consider keeping at least some of their money in stocks..
Those who are extremely wealthy do not have to risk investing in stocks because they do not need to grow their wealth (unless they live beyond their means).
Your risk tolerance is also important in deciding how much of your money to put into stocks and how much for bonds.
The more risk you are willing to take, the more money you should set aside for stocks. If you’re older, you should probably exercise some caution.
You probably shouldn’t change your asset allocation in response to short-term market movements. When stocks go down, as they are now, you may be tempted to reduce the weight of your stocks.
But the market will do it for you. If you hold bonds safe to maturity and the stock goes down, your stock allocation effectively goes down with the price of your stock.
An argument can be made to increase your allocation to stocks when the market is down because you will be picking them up at lower prices than you would have previously.
In the end, many of you are likely to do your best if you don’t make any changes to your investment portfolios in response to higher Fed rates and their negative impact on stocks. Staying on the course is often the best course of action.