Diversifying A Millennial Investment Portfolio: How Much In Stocks, Bonds & Cash?
If you have an investment portfolio you will almost certainly have heard of the concept of ‘diversification’. A portfolio’s ‘diversification’ is how its value is split between different asset classes. That means not just lots of different examples of one asset class – like equities. But between different kinds of investments such as equities, REITs, bonds and cash. Diversification keeps an investment portfolio more stable during stock market downturns and, long term, that lower volatility has been demonstrated to result in better overall returns.
Diversifying well means knowing how much money to allocate to the different investment classes and also how to add variety within these allocations. And the balance should be adjusted depending upon your age. If you are a millennial still many years from retirement, your advised diversification balance will be different to someone 10 or 2 years from retirement.
The Different Kinds Of Investment
The average investment portfolio will usually include three main components:
Some financial advisors recommend including a fourth – REITs (Real Estate Investment Trusts).
There are other kinds of investment you can also make such as property and alternative investments such as collectables. But they don’t offer the same liquidity and convenience as investments that can be bought and sold online with the click of a button. They are also not regulated. That doesn’t mean other kinds of investment don’t have strengths that can complement an online investment portfolio but here we’ll stick to the core that anyone can build their long term investment goals.
Each of the investment classes in a diversified portfolio offer something different to the mix:
- Equities, whether bought as funds or individual company stocks, help a portfolio to grow over time.
- Bonds offer steady, low risk income.
- Cash gives a portfolio stability and allows it to recover when markets are down.
- REITs provide a hedge against inflation and low correlation to equities.
How Should A Millennial Diversify An Investment Portfolio?
Unless you are a particularly sensible young millennial who is already investing towards retirement by the age of 25, we can probably presume a majority of millennial investors are aged between around 30 and 35 or so. Which means you probably have 30-35 years-ish of working life ahead of you. Unless you manage to build up a big enough investment portfolio to retire early.
That means you don’t need to worry much about market volatility. Historically, stock markets have always gained over the long term. Stock market crashes and bear markets, periods over which stock prices are falling, eventually give way to a new bull market, when stock prices are rising. Drops tend to shorter and sharper than gains.
The chart below shows the history of the UK’s FTSE 100 benchmark index stretching back to the 1980s. We can see bear markets between the year 2000 and 2003 and again between 2007 and 2009. The stock market has some smaller blips in between those bigger bear market but they are short lived and the general trend is upwards.
While there is no absolute guarantee, we can presume a similar pattern will unfold over the next 30 years. The stock market will have its ups and downs but generally so its value grow over the long term.
How many years you are from retirement is important because stock market crashes and bear markets are only a problem if you have to sell your investments during them. Then you lock in losses. If you don’t have to sell, you just wait for the market to recover and, hopefully, go on to greater heights. In fact, if you are a long way from retirement market crashes are good for the overall value of your investment portfolio. If you are investing a portion of your income every month you will buy the same investments cheaper during down times, realising the strongest returns as the market recovers. Really, the more you can invest during stock market crashes and bear periods, the better.
How Much Of My Investment Portfolio Should I Hold In Cash?
Which brings us to the cash part of a diversified investment portfolio. Cash might not seem like an ‘investment’. It’s just cash, right? There is no risk to reward involved. But it has two important roles in an investment portfolio.
The first is as a buffer to make sure you don’t have sell investments at a loss, or opportunity cost, when markets are down. Once you are retired you will probably be relying on your investment portfolio for an income. If it’s big enough, your income will hopefully be able to come from dividends and capital gains generated over the year without selling any of the investments generating that income.
This will mean your investment portfolio will last as long as you need it to. And if your investment portfolio is not quite big enough for just its generated returns to give you enough to live from you will still want to carefully manage how you gradually cash the investments in over the years so it lasts.
If markets go into a down period and your investment portfolio loses value, it won’t be producing returns for a while. Potentially up to 2 or 3 years. At that point you use the cash component of your portfolio, spending it instead of selling investments. Eventually the stock market will recover and your investments again produce returns. These should be especially strong over the initial period of the recovery, allowing you to replenish your cash buffer for future bumps along the road.
As a millennial investor, that requirement for cash as part of your portfolio’s diversification is a long way off. You only need it as a buffer if you are taking a regular income from your investments. So for the next decade or two you can focus on equities, with some allocation to bonds, to grow your portfolio’s value. Cash won’t help there. In fact, with interest rates currently running below inflation, cash will actually decrease in real value.
That doesn’t mean you shouldn’t hold any cash. But you only need a small allocation. Enough to cover around 3 months’ living expenses is generally advised. This covers you in the event of emergencies or temporary unemployment. A 3-month cash buffer will both give you peace of mind and mean you don’t eat into your investments if you have temporary cash flow issues.
And holding a modest cash reserve has another important advantage. If markets do crash or go into a bear period, you can use it to buy up more investments at cheaper prices. Your portfolio’s value will get a nice additional boost when the recovery takes hold. A great tip in this circumstance is to not to try and ‘time’ the bottom of the market. Drip feed you cash into investments a little at a time every month. That way you’ll be guaranteed at least some of it is invested at or near the bottom of a bear market.
As you get closer to retirement you can gradually increase the amount of cash you hold, particularly when you get into the last 5 years. By the time you are actually retired, it would be ideal to have 2-3 years of living expenses in cash as part of your investment portfolio mix.
How Much Of My Investment Portfolio Should I Hold In Equities and Bonds?
There’s no black and white answer to this question but the further you are from retirement that more you should hold in equities and the least in bonds. Bonds are a ‘stabiliser’ that helps reduce losses when stock markets go down. They also produce income which varies on the risk level of the bonds.
Government bonds such as gilts in the UK are considered to be very secure investments (the only risk is that the British government defaults). As such they pay low interest rates of usually between 1% and 1.5% which is lower than inflation. But corporate bonds can offer better interest rates of up to 3%-4%, ahead of inflation, while retaining a reasonably conservative risk profile. So you can diversify within your portfolio’s bond allocation in a way that means your bond income stays at least a little ahead of current inflation rates.
A rules of thumb often advised for how much of an investment portfolio should be allocated to bonds is to minus your age from 100. So if you are 30, you should allocate around 30% of your portfolio, minus your cash buffer, to bonds and the rest to equities. If you are 40, 40% and so on.
Diversification Within An Equities Allocation
For most of the time you are building up an investment portfolio, your biggest allocation will be to equities. Either through funds or buying individual stocks. Funds are an easier and safer way to go if you don’t have the time and/or knowledge to analyse individual stock picks yourself.
Equities are an investment portfolio’s engine of growth over the long term and also offer a huge amount of internal diversification potential. If, as a millennial investor, you start with a portfolio allocation of 70% to 80% in equities, you can break this down further.
10% or so can go to REITs, which offer similar income potential to equities but tend to do better when markets are down. Alternatively, this 10% or 15% can go to ‘income stocks’. These are companies such as utilities or infrastructure owners but not only. They don’t tend to see their value grow much as the companies are usually big and stable rather than high growth. But they are usually cash cows that pay out attractive dividends that can be reinvested.
At least a 20%-ish allocation should go to international equities. This means you are not just relying on the local London stock market but can spread the risk across other regions. Emerging markets are riskier but offer attractive long term growth potential. The younger you are the more risk you can afford to take on.
The rest of your portfolio can go to a nice varied mix of funds and individual stocks, if you feel qualified to do some of your own stock picking or want to set aside a little capital to gain experience doing so. Take care with fund fees as very similar offerings from different managers can often have significant discrepancies and high fees will eat into your compound returns over the years. Passive index trackers should form the bulk of your funds allocation with the rest managed funds that perhaps take on slightly more risk.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.