I write a handful of columns a year for ACEP NOW. This recent article originally ran here and is an answer to a complex question I frequently get.

Q. What Should the Mix of Stocks and Bonds Be in My Retirement Portfolio?

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A. Unfortunately, the answer to this simple question is incredibly complex and doesn’t even necessarily have a right answer. The short answer is, assuming future market returns resemble past market returns, you should invest as much of your portfolio in stocks as you can tolerate without selling low in a terrible bear market.

Unfortunately, explaining that sentence is going to take the rest of this article. The process of deciding how much of your portfolio to invest in what type of security, such as stocks, bonds, and real estate, is called asset allocation. It turns out that, in the long run, asset allocation (ie, determining the mix of risky assets such as stocks to less risky assets such as bonds) matters far more than individual security selection or your ability to time the market, so it is a great place to spend your limited financial planning time and effort.

The mix of assets determines both your long-term return as well as the volatility of the portfolio. Now, upward volatility rarely bothers investors—it’s the pesky downward volatility that represents losing the money you invested for retirement instead of spending it on a kitchen remodel. Let’s just focus on that. Vanguard, the only mutual fund company owned by its investors, put together a nice study of asset allocation models using data from 1926 to 2015 that gives an idea of the return and worst annual period (but not necessarily worst peak to trough) you could expect in the past with a given stock-to-bond ratio. I summarize its data in Table 1.

Table 1: Historical Return and Maximum Drawdown from Stock-Bond Ratios. Source: Vanguard; personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations.

There Are a Few Things That Can Be Learned From Table 1

1) There is a general correlation between risk and return. If you were willing to tolerate the possibility of bigger losses, you experienced higher returns. The difference between earning a 10 percent return and an 8 percent return is not insignificant. Over 30 years, investing the same amount every year, a 10 percent return results in your nest egg, your retirement income, being 48 percent larger than what you would have with an 8 percent return.

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2) There is no mix of stocks and bonds that eliminates the possibility of loss. Investing means losing money. If you invest, your portfolio will decline in value from time to time. This should be expected, but do your best to increase your ability to tolerate that volatility.

3) Stocks are risky. While the worst year for a 100 percent stock portfolio was a 43.1 percent loss, that understates the way a loss feels. That figure comes from the loss from Jan. 1 to Dec. 31, not the peak-to-trough, which is the percentage decline from the fund’s highest net asset value (peak) to the lowest net asset value (trough) after the peak. For example, in 2008, the US stock market lost 37.1 percent. However, the peak-to-trough loss was -48.4 percent. It was even worse if you extend the period to the bear market bottom in March 2009 (-52.9 percent). Basically, in a nasty bear market, you should expect to lose about 50 percent of the value of whatever portion of your portfolio you invested in risky assets such as stocks.

The Psyche of Losing 40-50% of Your Money

If you have not lost real money in a bear market before, it is a bit difficult to understand how it feels. It is not a matter of logically looking at a 40 percent to 50 percent loss and saying, “I’ll tolerate that because I want those 10 percent returns.” It is more of a visceral feeling of loss. While intellectually you may be able to tolerate that sort of loss, emotionally you may not be able to withstand the very real pressure from your partner, family members, co-workers, media, and your own psyche. Experienced physician investors compare it to the sleepless nights associated with being named in a medical malpractice lawsuit.

Staying With Your Plan in a Bad Bear Market

No turning back now. She’s got to stick with the plan.

To make matters worse, if you succumb to that pressure and abandon your plan in the depths of a bad bear market, the results will be far worse than if you had just invested a little less aggressively in the first place. Thus, to get the highest possible returns, you generally want the highest stock-to-bond ratio that you can tolerate without selling out at a market bottom. Unfortunately, most people don’t know what they can tolerate until they have invested through a nasty bear market, such as 2008–2009. There are many attending physicians in the workforce who have never done that. My advice is to pick an asset allocation that is less aggressive than what you think you can tolerate, at least until you pass through your first bear and prove your risk tolerance to yourself. Don’t overestimate your ability to sleep well while hemorrhaging money.

Hedging Against the Risk of a Permanent Decline in Stock Value

There is another factor to consider. The data in Table 1 comes from the past. Physicians in the evidence-based medicine era are all quite familiar with the limitations of retrospective data. The future does not necessarily have to resemble the past. The real risk of stocks is not that they will decline in value temporarily, but that they will decline in value permanently. While that risk is likely fairly low, it’s not zero. Owning some less risky assets in the portfolio is a good way to hedge against that unlikely possibility.

In addition, many investment authorities expect future returns, at least for the next decade, to be lower than the historical averages due to low interest rates and high stock valuations. While my crystal ball is cloudy about what the future holds for stock market returns or interest rates, it’s important to realize that if your retirement plan relies on your achieving historical rates of return to succeed, it may not be as robust of a plan as you think. You may need to save more, work longer, or even take more risk with your investments than you would like, knowing that the risk of running out of money in old age may be worse than the risk of losing money in the markets.

Decide Carefully and Then Stick With Your Chosen Plan

Asset allocation is a personal decision that you should make after careful consideration and in consultation with your advisors and those you care about. While there is little performance difference between a 65-35 portfolio and a 60-40 portfolio, you need to get your asset allocation in the right ballpark and then stick with it through thick and thin to reach your financial goals.

Did you stick with your plan during the last bear market? How did you mentally deal with losing 40-50% of your investment? Did you change your allocation as a result? What asset allocation lets you sleep well at night? Sound off below!