This Standard Piece of Investing Advice Is Too Risky

(Bloomberg Opinion) -- My mother is 73 years old. She has a nice sum of money saved up from a long career as a public servant that is invested in two mutual funds. One is a high dividend fund that mostly consists of international stocks, and the other is a short/medium duration corporate bond fund. Her investment objective is to earn income, and the blended portfolios yield about 4 percent. She has a 43 percent allocation to stocks.

Twice in the last year her financial adviser approached me and asked whether it's time to diversify her into “aggressive growth stocks.” The second time it happened, I gave him an abridged version of my thesis on asset allocation. I said the problem with people and money isn't that they don't have enough of it, but rather it's that their money causes them stress, and the primary source of that stress is debt and risk. My mother sustained a miniscule drawdown during the market swoon at the end of last year. If she had been 100 percent in aggressive growth stocks, it would have been much worse.

From my travels, I have come to suspect that a surprising number of individual investors have a 100 percent allocation to equities. That's a lot of risk. Even personal finance guru Dave Ramsey, whose following extends across the Southeast, recommends a 100 percent allocation to equities, mostly in growth stocks.

The reason you don't want a 100 percent allocation to equities is because volatility makes people make stupid decisions. During the financial crisis, when the S&P 500 Index plunged almost 60 percent, not too many people “held on” and dollar-cost averaged the whole way down. After suffering such losses, most people will conclude that the stocks they hold might go down the last 40 percent, and so they take action to conserve whatever capital they have left. But what typically happens is that people sell at the worst possible time and then watch helplessly as the market rebounds.

Financial advisers will generally recommend what has become the standard asset allocation, which is 80 percent in stocks and 20 percent in bonds, with investors allocating more to bonds as they age. But even that is too risky. Some well-known hedge funds have put out papers saying that even a 60/40 portfolio isn't well diversified when viewed from the perspective of how each asset class contributes to the overall risk of the portfolio.

I propose an allocation to stocks of 35 percent for all investors in all circumstances, and an allocation to bonds of 65 percent. The reason being is that most advisers focus on returns to the exclusion of all else. They start by asking how much money you want in retirement, then they have you figure out how much you are willing to contribute and back out the rate of return you need. Most people assume an 8 percent return from an equity portfolio. I'm not going to quibble with the historical returns of the stock market—everyone knows what they are—but I will say that few people realize those returns because of suboptimal behavior along the way. In other words, buying on the highs and selling on the lows. Or, they only faithfully dollar cost average on the way up.

This has given rise to a cottage industry of advisers who put their clients into low-fee index funds and then engage in “behavioral coaching” to make sure they don't take their money out of the market at the worst possible time. It's a little odd to pay someone to tell you to do what you should be able to do on your own, but an adviser wouldn't even be necessary if you didn't have a portfolio that scared the bejeezus out of you once every few years. It wouldn't be necessary if you had a portfolio that you could set and forget.

A 35/65 portfolio has a higher Sharpe Ratio, or better risk/return characteristics. Such a portfolio is suitable for all people at all ages because the goal here is not to target returns but to target volatility and minimize risk. If you minimize risk, then you minimize stress. If you minimize stress, you minimize suboptimal behavior. Naturally, you can adjust the allocation to equities slightly based on an investor's age, but the 35/65 allocation is a good baseline.

Critics will rightly say that this portfolio simply won't return enough for people to retire comfortably, or at least hasn't historically. That is a legitimate concern. My answer is that investors simply need to save more. While at 6 percent the savings rate is higher than before the financial crisis, it's well below the average of more than 10 percent from the 1950s to the mid-1980s. People will tend to save less if they believe the 8 percent actuarial return of the stock market given to them by their advisers. If people had more realistic expectations of what they could earn in the market, it might cause them to be more conservative with their personal finances.

The thesis here is that investors, over time, will achieve higher returns with a set-it-and-forget-it 35/65 portfolio than in a more volatile portfolio of mostly stocks that induces suboptimal investor behavior. In that sense, do-it-yourself investing really becomes possible and cheaper. You don't need to pay someone to tell you what you already know to do.

Advisers should stop targeting return and start targeting volatility. Figure out what volatility a client can handle and use that to design a portfolio. Rich people with their hedge funds get to look around for money managers who care about things such as the Sortino Ratio, which is a measure of downside volatility, and max drawdowns. These are discussions you never have when shopping for S&P 500 index funds. Returns of 8 percent are fine until they stop compounding. The magic of compounding only works if you are actually compounding.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World." He may have a stake in the areas he writes about.