The Most Important Decision You'll Make About Your Portfolio

A lot of decisions will affect the future value of your portfolio - which investments you buy, how much you concentrate your portfolio into those investments, and when you decide to sell them. But it all starts with one very important question: How much risk are you going to take? For most investors, that question begins to be answered with the decision of how much they'll put in the stock market, and how much to keep safer in cash and bonds.

Choosing the right stock/bond mix

The amount of your portfolio you keep out of the stock market is determined by four factors.

1. When you'll need the money
If the purpose for which you're investing is on the horizon - within the next three to five years - then keep that money in cash, certificates of deposit, or a short-term bond fund. From 1926 to 2011, stocks beat bonds in 60 percent of one-year periods, according to Ibbotson Associates. That percentage increases as the number of years measured increases. So, depending on how firm your need for the money, and the flexibility of the timing of your goal, the more money you should keep out of stocks.

2. Your risk tolerance based on history

The term “risk tolerance” gets thrown around so much that it's become almost meaningless, especially since risk means different things to different people. In the context of deciding your stock/bond mix, risk generally means how much of a decline can you stand before you can stand no more - at which point you sell your stocks after a significant drop.

But another aspect of risk is the uncertainty of future returns, and thus the uncertainty of whether you'll have enough money to do what you want. While stocks have historically outperformed bonds over the past 80-plus years, the record is not quite as definitive when returns are broken up by decade. The table below shows the compound average annual returns of different mixes of large-cap U.S. stocks and long-term government bonds over the past four decades, as well as the worst one-year return for each allocation since 1926.