Every so often, a well-meaning "expert" will say long-term investors should invest 100% of their portfolios in equities. Not surprisingly, this idea is most widely promulgated near the end of a long bull trend in the U.S. stock market. Below we'll stage a preemptive strike against this appealing, but potentially dangerous idea.

The Case for 100% Equities

The main argument advanced by proponents of a 100% equities strategy is simple and straightforward: In the long run, equities outperform bonds and cash; therefore, allocating your entire portfolio to stocks will maximize your returns.

Supporters of this view cite the widely used Ibbotson Associates historical data, which "proves" that stocks have generated greater returns than bonds, which in turn have generated higher returns than cash. Many investors—from experienced professionals to naive amateurs—accept these assertions without further thought.

While such statements and historical data points may be true to an extent, investors should delve a little deeper into the rationale behind, and potential ramifications of, a 100% equity strategy.

Key Takeaways

  • Some people advocate putting all of your portfolio into stocks, which, though riskier than bonds, outperform bonds in the long run.
  • This argument ignores investor psychology, which leads many people to sell stocks at the worst time—when they are down sharply.
  • Stocks are also more vulnerable to inflation and deflation than are other assets.

The Problem With 100% Equities

The oft-cited Ibbotson data is not very robust. It covers only one particular time period (1926-present day) in a single country—the U.S. Throughout history, other less-fortunate countries have had their entire public stock markets virtually disappear, generating 100% losses for investors with 100% equity allocations. Even if the future eventually brought great returns, compounded growth on $0 doesn't amount to much.

It is probably unwise to base your investment strategy on a doomsday scenario, however. So let's assume the future will look somewhat like the relatively benign past. The 100% equity prescription is still problematic because although stocks may outperform bonds and cash in the long run, you could go nearly broke in the short run.

Market Crashes

For example, let's assume you had implemented such a strategy in late 1972 and placed your entire savings into the stock market. Over the next two years, the U.S. stock market lost about 40% of its value. During that time, it may have been difficult to withdraw even a modest 5% a year from your savings to take care of relatively common expenses, such as purchasing a car, meeting unexpected expenses or paying a portion of your child's college tuition.

That's because your life savings would have almost been cut in half in just two years. That is an unacceptable outcome for most investors and one from which it would be very tough to rebound. Keep in mind that the crash between 1973 and 1974 wasn't the most severe, considering what investors experienced between 1929 and 1932, however unlikely that a crash of that magnitude could happen again.

Of course, proponents of all-equities argue that if investors simply stay the course, they will eventually recover those losses and earn much more than if they get in and out of the market. This, however, ignores human psychology, which leads most people get into and out of the market at precisely the wrong time, selling low and buying high. Staying the course requires ignoring prevailing "wisdom" and doing nothing in response to depressed market conditions.

Let's be honest. It can be extremely difficult for most investors to maintain an out-of-favor strategy for six months, let alone for many years.

Inflation and Deflation

Another problem with the 100% equities strategy is that it provides little or no protection against the two greatest threats to any long-term pool of money: inflation and deflation.

Inflation is a rise in general price levels that erodes the purchasing power of your portfolio. Deflation is the opposite, defined as a broad decline in prices and asset values, usually caused by a depression, severe recession, or other major economic disruptions.

Equities generally perform poorly if the economy is under siege by either of these two monsters. Even a rumored sighting can inflict significant damage to stocks. Therefore, the smart investor incorporates protection—or hedges—into his or her portfolio to guard against these two threats.

There are ways to mitigate the impact of either inflation or deflation, and they involve making the right asset allocations. Real assets—such as real estate (in certain cases), energy, infrastructure, commodities, inflation-linked bonds, and gold—could provide a good hedge against inflation. Likewise, an allocation to long-term, non-callable U.S. Treasury bonds provides the best hedge against deflation, recession, or depression.

A final word on a 100% stock strategy. If you manage money for someone other than yourself you are subject to fiduciary standards. A pillar of fiduciary care and prudence is the practice of diversification to minimize the risk of large losses. In the absence of extraordinary circumstances, a fiduciary is required to diversify across asset classes.

Your portfolio should be diversified across many asset classes, but it should become more conservative as you get closer to retirement.

The Bottom Line

So if 100% equities aren't the optimal solution for a long-term portfolio, what is? An equity-dominated portfolio, despite the cautionary counter-arguments above, is reasonable if you assume equities will outperform bonds and cash over most long-term periods.

However, your portfolio should be widely diversified across multiple asset classes: U.S. equities, long-term U.S. Treasuries, international equities, emerging markets debt and equities, real assets, and even junk bonds.

Age matters here, too. The closer you are to retirement, the more you should trim allocations to riskier holdings and boost those of less-volatile assets. For most people, that means moving gradually away from stocks and toward bonds. Target- date funds will do this for you more or less automatically.

If you are fortunate enough to be a qualified and accredited investor, your asset allocation should also include a healthy dose of alternative investments—venture capital, buyouts, hedge funds, and timber.

This more diverse portfolio can be expected to reduce volatility, provide some protection against inflation and deflation, and enable you to stay the course during difficult market environments—all while sacrificing little in the way of returns.