In two books I’ve read recently (The Investor’s Manifesto by William Bernstein and The Little Book of Main Street Money by Jonathan Clements), the authors make the case that young investors should have a conservative asset allocation until they’ve been through a bear market.
The argument is that most people tend to overestimate their tolerance for volatility and that there’s no way to really know how you’ll respond to a big decline in your portfolio value until you’ve personally experienced it.
I’d agree with that.
Bernstein suggests, therefore, that “market virgins” (his term) limit their stock allocation to 50% of their total portfolio.
I don’t agree with that.
For Example…
Let’s imagine a hypothetical 25-year old investor named Ruth. Ruth has $10,000 in her 401(k), and, following Bernstein’s advice, she has 50% in stocks and 50% in bonds.
The market goes through a calamitous 50% decline. Ruth’s 401(k) is now worth $7,500 (assuming the bonds’ value doesn’t change at all)–a loss of $2,500. Ruth is perfectly calm. Not the slightest worry.
So Ruth concludes that she has a high risk tolerance, and she adjusts her allocation to be 80% stocks, 20% bonds.
The market marches happily upward for four years, by the end of which Ruth has $50,000 in her 401(k)–still 80% stock, 20% bond. Then, the market goes through another 50% decline. This time (if we again assume the bonds go nowhere), Ruth’s 401(k) loses $20,000 in value.
Doesn’t it seem possible that Ruth might respond differently to a $20,000 loss than she did to the $2,500 loss a few years back?
Test Yourself While You’re Young
It seems to me that it’s difficult to draw any meaningful conclusions about your volatility tolerance if you:
- Have a very conservative allocation, and
- Have a small amount invested (like you do when you’re young).
I’d argue that investors should test themselves when they’re young by using an aggressive allocation. If you find that you can’t stomach the volatility, isn’t it better to learn that sooner rather than later?
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I think you make an important point here: people really don’t know how much volatility they can withstand until they actually lose the money. So, I guess you are right. It is better to find out sooner than later.
Mike: “Doesn’t it seem possible that Ruth might respond differently to a $20,000 loss than she did to the $2,500 loss a few years back?”
Of course. If she’s learned from the experience, she might just shrug it off as another cycle of inevitable market volatility. If she’s really learned, she’ll see she’s now got an allocation of 66.66/33.33, and she’ll rebalance back to 80/20. This way she’s buying stocks low and will have more shares in her stock fund for when the next rebound starts. At age 29, she’s got 20-25 years to absorb any market volatility.
But note those two “ifs.”
Though I myself am yet a pre-virgin (no investments yet due to high interest debt repayment) with very little proper knowledge of investments, I would tend to agree with you based on the scenario you laid out above.
On your recommendation I am reading this book now, and am looking forward to putting the knowledge gained into practice as soon as my high interest debt is gone.
I’m surprised that I’m disagreeing with two of my favorite writers (Bernstein and Clements), but I don’t see things the same way.
The market doesn’t decline by 50% every few years. It could be 1 year or it could 20 years before an investor is really tested on their risk tolerance. If you waited around for a crash, that can be an awfully long time of forgoing stocks.
I think people respond to loss by its absolute size, not necessarily by percentage. If it’s true, it doesn’t help if a young person starts with 80% in stocks. To use your example, suppose Ruth loses $4,000 in a bear market and remains calm, and therefore she concludes she can tolerate the risk of having 80% in stocks. When her portfolio gets to $50,000 and she loses $20,000, doesn’t it seem possible that Ruth might respond differently to a $20,000 loss than she did to the $4,000 loss a few years back? Changing the number from $2,500 to $4,000 doesn’t change the picture much.
That’s why I proposed the risk tolerance metric loss to income ratio. People can relate to their take-home pay. Ask yourself how many months of take-home pay you are willing to lose in a bear market when stocks lose 50% of their value. Use that number to come up with your asset allocation.
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