When determining how to invest 1 million dollars, age, risk tolerance and goals will become important factors. Depending on how old you are, your goals and income needs might change. Whether you’re still earning money from a regular income from employment or a business will also be a factor. Your risk tolerance is a huge element that needs to be considered that is often overlooked by individuals who view investing more as return maximalism compared to risk management. Lastly, your investment goals will largely dictate the best way to invest a million dollars, as well.
In this guide to learn how to invest 1 million dollars, we will discuss the following:
- How to invest 1 million dollars based on age range
- Portfolio design approaches
- An example asset allocation to consider
- Why should we invest in bonds?
- Understanding returns, standard deviation and Sharpe ratio
How to invest 1 million dollars based on age range
How you invest a pile of money is partly determined by your age. If you’re younger with quite a bit of human capital and high earning potential, then you don’t need your investments for the income most likely. Alternatively, if you’re close to retirement age, you might be phasing out of the work force either by choice or necessity and may need the income to live on. These scenarios are quite different from one another and will likely lead to very different portfolio designs. Let’s look at some specific examples of how to invest 1 million dollars for different age groups.
How to invest 1 million dollars if you’re 30 years old
If you’re in your 30s, you are entering a phase where typically your earning power is growing. Perhaps not yet peak earning time for your career, but approaching it. Unless you’re trying to do some extreme retire early scenario, you’re also likely working which means you don’t need your investment portfolio to generate income to live on. So, you can take a long-term approach here.
Since the stock market has never lost money over a 20-year period no matter when you would have invested, your stock allocation should be very heavy on equities. It doesn’t necessarily mean 100% equities, but it probably means at least 80% equities. Most advisors would recommend a mix of index funds getting exposure to the various broad based US market indices as well as some international exposure.
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How to invest 1 million dollars if you’re 40 years old
If you’re in your 40s, you may be eyeing a time when you can hang up the work clothes and move to some sort of retirement phase if you have already piled up a decent amount of assets. By eyeing a retirement, we don’t mean immediate, but it could be even 10 or 15 years out. As such, you may not want to stomach a major downturn in the stock market. So, perhaps your equity exposure is somewhat less than someone in their 30s. Still heavy on equities, you might consider a 70% stocks / 30% bonds mix.
How to invest 1 million dollars if you’re 50 years old
If you’re 50 or older, it’s important to ensure you don’t get hit hard by a market downturn. While a more conservative allocation means you won’t get all of the upside of a bull market, you will also protect your investments in the case of some major volatility. Reducing the volatility of your portfolio will help you sleep at night. During a major bull market, it’s important to keep in mind your overall strategy and not alter it based on a fear of missing out of higher returns.
How to invest 1 million dollars if you’re 60 years old
During this phase, capital preservation and modest growth is the priority. Many people at this phase opt for a conservative allocation of anywhere from 60% stocks / 40% bonds to perhaps even 50% stocks / 50% bonds. Depending on your income needs and the size of the portfolio, it can help dictate where on the asset allocation range you end up landing. If your portfolio is large (say, several million dollars), then perhaps you’re fine with a more aggressive allocation. If the portfolio is smaller, your risk window is narrower and you may need to go with a more conservative allocation and simply manage your lifestyle as a result.
Portfolio design approaches
Asset allocation focus: Stocks & bonds mix
At a simple level, most portfolios are designed with a stocks & bonds asset allocation in mind. While each basket can have multiple components, it’s common for most of the portfolio design to be concerned with how to split the stocks and bonds allocation. For instance, should you be 90% stocks / 10% bonds? 50% stocks / 50% bonds? Etc.
Vanguard’s asset allocation models page has some useful information for considering the performance and volatility of the various asset allocation models.
- 100% stocks / 0% bonds
- Average annual return: 10.1%
- Best year: 54.2%
- Worst year: -43.1%
- Years with a loss: 26 of 93
- 80% stocks / 20% bonds
- Average annual return: 9.4%
- Best year: 45.4%
- Worst year: -34.9%
- Years with a loss: 24 of 93
- 70% stocks / 30% bonds
- Average annual return: 9.1%
- Best year: 41.1%
- Worst year: -30.7%
- Years with a loss: 23 of 93
- 60% stocks / 40% bonds
- Average annual return: 8.6%
- Best year: 36.7%
- Worst year: -26.6%
- Years with a loss: 2 of 93
- 50% stocks / 50% bonds
- Average annual return: 8.2%
- Best year: 32.3%
- Worst year: -22.5%
- Years with a loss: 18 of 93
- 40% stocks / 60% bonds
- Average annual return: 7.7%
- Best year: 27.9%
- Worst year: -18.4%
- Years with a loss: 17 of 93
- 30% stocks / 70% bonds
- Average annual return: 7.1%
- Best year: 28.4%
- Worst year: -14.2%
- Years with a loss: 15 of 93
- 20% stocks / 80% bonds
- Average annual return: 6.6%
- Best year: 29.8%
- Worst year: -10.1%
- Years with a loss: 13 of 93
- 0% stocks / 100% bonds
- Average annual return: 5.3%
- Best year: 32.6%
- Worst year: -8.1%
- Years with a loss: 14 of 93
To best identify the right asset allocation, you need to know yourself. Are you going to be tempted to emotionally react and sell stocks in the case of a major market correction? If so, you need to protect your portfolio against yourself and go with a more conservative asset allocation. Are you able to stomach short-term volatility because you understand the long-term nature of investing in equities? Then, you can likely go with a more aggressive allocation. Truly, knowing your own tendencies and behaviors when investing is one of the biggest pieces of the puzzle here. Be sure you’re honest with yourself so you can set yourself up for maximum success.
The other important thing to note is that your goal isn’t always the highest return. Getting the highest return typically comes with the most risk. You’re managing the balance between return and risk. You’re not going for the best return. So, if you identify that, say, the 70% stocks / 30% bonds split is right for you, you need to be disciplined and content with your strategy and not be tempting by recent outperformance of a higher equities portfolio. Remember why you chose that allocation in the first place. You’re managing risk, not just going for the best return.
Short-term money & long-term money
Another way of looking at portfolio construction whether you are investing 1 million dollars or a different sum can be the method of short-term money and long-term money. Rather than constructing a portfolio based on asset allocation, the portfolio can be constructed along the lines of short-term needs and long-term needs. Short-term needs can sometimes be viewed as emergency funds or income generated for lifestyle.
Let’s start with the emergency fund approach. Let’s consider the following scenario: You are investing 1 million dollars, want to ensure always have 3 years of expenses allocated in low-risk, short-term money and you need $50,000 per year to live. You could then determine that you want to allocate $150,000 of the $1 million and put it in short-term money. The rest, or $850,000, will be in long-term allocation and won’t be touched. The $150,000 short-term allocation should be put in low-risk bonds and other cash instruments, and the other $850,000 should be put in equities (or something similar to a 85% stocks / 15% bonds split). But what are you living on? Ideally, in this scenario you have enough income from social security, other income sources, and the returns generated from the $150,000 short-term money to fund your lifestyle. Now, this might not be sufficient for needed income, so let’s focus more on income in the next scenario.
If we’re approaching this more for income generation, our goal might be to generate enough income in low-risk, short-term money so that we can have a chunk of money dedicated to long-term holdings that we never have to touch. Let’s say you need $50,000 to live on each year and have $20,000 each year in social security income. Well, you can structure your portfolio by allocating enough money in short-term assets to generate $30,000 annually, then put the rest in long-term holdings. In this scenario, let’s say the short-term holdings can reliable produce 3.5% in annual cash flow. This means you’ll need just over $850,000 in your short-term allocation, then the rest goes into long-term holdings. If you’re investing $1 million, then this means a very heavy bond splits with very little in equities. If you’re investing a much larger sum, something like $4 million, then of course, you’ll have over $3 million in an equities position that you won’t touch and will be left to grow.
How to invest a million dollars for income
It’s a common question for people who have come into some money whether through an inheritance or perhaps an asset sale. How should I invest a million dollars for income? How can I take a million dollars and generate enough income to live on?
The idea of a safe withdrawal rate is a common concept in retirement planning. A 4% withdrawal rate is often cited as a safe place to be. If you subscribe to this line of thinking, then you can look at a million dollar portfolio and assume you can pull out 4% each year, or $40,000, to live on and not be at a substantial risk of running out of money.
There are risks to this line of thinking, namely sequence of returns risk. While at first glance, it might appear that generating 4% cash flow from a portfolio that historically has resulted in something like 7% average annual returns is not a risky proposition, this can be deceiving. Depending on market activity, especially early on during this phase of retirement or during the phase of needing income from this portfolio, you may or may not run out of money. You might be rolling the dice hoping for a cooperative market, and you might get one. But you might not. This is sequence of returns risk. In a previous article, we described sequence of returns risk as follows:
The sequence of returns refers to the timing of stock market returns. If you have very good years in the market early on in your retirement, it will help your funds last longer. If you have very bad years in the market early on in your retirement, the risk of running out of money goes up dramatically. Why? Because if your funds lose value due to stock market declines AND you are withdrawing money during this time to pay things like your mortgage, food, healthcare, etc., then you’re creating permanent losses in your retirement funds that you don’t get back even if the market bounces back significantly. This is why average returns over time are very, very deceptive to retirees.
Because of this, if you definitely need $40,000 or more in annual income from a million dollar portfolio, you might be at risk of running out of money if you incur a market correction early on. If you incur the opposite, a major bull market, then you might be completely fine. There is a bit of luck involved here.
The alternative to rolling the dice on sequence of returns is allocating the million dollar sum into an annuity. If you’re right on the edge of risking running out of money or not, you can essentially remove this risk by going the path of an annuity. This will likely result in a lower annual payout (perhaps say $32,000 instead of $40,000). This will leave you to focus on managing your lifestyle and expenses against the guaranteed payments of the annuity, but you’ll be able to sleep at night and not be concerned about stock market fluctuations. Remember, there’s a tremendous amount of risk management involved for most retirees. Running out of money is a significant issue as it’s not easy to jumpstart income generation at an elderly age. It’s better to accept a lower standard of living and remove the risk of running out of money.
An example asset allocation to consider
Just for example purposes, we’re going to map out a specific asset allocation. Where possible, we will use low-cost Schwab ETFs. In this portfolio, we won’t be picking stocks, but will be using very broad based ETFs to achieve a relatively simple asset allocation that most investors will be able to understand. Of course if you want to keep it super simple, you can go with a three-fund portfolio design that is popular with followers of John Bogle (Vanguard). We describe the three-fund portfolio in a previous post as follows:
The three-fund portfolio essentially aims to provide broad, diversified exposure to US stocks, US bonds and international stocks. You can get super low-cost ETFs and accomplish a very diversified portfolio that performs very well historically by just buying three simple ETF funds. Here are examples at the three large brokerages:
- Schwab: Total Stock Market (SCHB), International (SCHF), Bond Index (SCHZ)
- Fidelity: Total Stock Market (FZROX), International (FZILX), Bond Index (FXNAX)
- Vanguard: Total Stock Market (VTI), International (VXUS), Bond Index (BND)
Again, the three-fund portfolio is a really nice place to start. Some investors like to add a small percentage to some alternative investors such as real estate investment trusts (REITs), but unless you’re pretty familiar with investing already, I’d stick to the simple allocation as outlined above.
Again, for illustrative purposes, let’s outline a slightly more complex asset allocation model as compared to the overly simple three-fund portfolio (however, you’ll notice how the three-fund portfolio is somewhat used as the basis for this asset allocation).
A few things to note about the above allocation:
- This is generally speaking a 70% stocks / 30% bonds allocation.
- The international equities portion is pretty low. I did this since international stocks have underperformed over the last decade quite a bit, but perhaps one might consider taking the opposite approach and doing a larger allocation to international. Backtesting the allocation is better with a lower international allocation, but that doesn’t mean it won’t do much better in the decade ahead.
- All ETFs chosen are Schwab ETFs except for the tax-exempt bond ETF (VTEB) which is a Vanguard fund. You can see the fees for each ETF are listed, and they are all quite low.
So how has this allocation performed? We can look at the past decade of annual returns and compare both the return and the volatility to the S&P 500 to get a sense for how it’s performed.
For the time period of 2010 – 2019, our asset allocation performed as follows:
- Average annual return: 9.85%
- Best year: 15.93%
- Worst year: -2%
- Standard deviation: .0679
- Sharpe ratio: 1.45
Note that not all ETFs in the allocation go back to 2010, so we used similar instruments in those early years which closely track the ETFs shown.
This compares to the S&P 500 over the same time period as follows:
- Average annual return: 14.15%
- Best year: 32.39%
- Worst year: -4.38%
- Standard deviation: .1226
- Sharpe ratio: 1.154
We can see that the S&P 500 outperformed out allocation on a straight returns basis, but our allocation had reduced volatility and produced better risk-adjusted returns (as indicated by a higher Sharpe ratio).
If you’re like me, you might not 100% trust this backtest since it doesn’t include any major down years in the market. After all, the market has basically gone straight up over the last decade as evidenced by the annual S&P 500 returns of 14.15% over the time period. So what if we include the 2008 year in our data set? How does that change things? Well, first let’s discuss what happened in 2008. During that calendar year the S&P 500 registered a -37% loss. Ouch. How did our allocation do in that particular year? Down 26.68%. Obviously a 27% loss is very painful, but the portfolio did its job in the sense that it muted a major market downturn and our portfolio had reduced volatility during that year. Now let’s look at the overall 2008, 2010-2019 data set (same as above but also including the 2008 year):
Our asset allocation:
- Average annual return: 6.53%
- Best year: 15.93%
- Worst year: -26.68%
- Standard deviation: .1276
- Sharpe ratio: .512
- Average annual return: 9.5%
- Best year: 32.39%
- Worst year: -37%
- Standard deviation: .193
- Sharpe ratio: .492
Again the S&P 500 had higher overall average returns, but our asset allocation had reduced volatility and a better risk-adjusted returns result.
So, why do we care about this? Why does this matter? Well, because we’re people and we’re human. And humans have emotions. Are you sure that if you’re no longer working and you rely entirely on your investments that you’re going to be able to weather a major market downturn and not make panic-based adjustments to your investment strategy? Like really sure? This is huge and can’t be overstated.
Sure everyone loves the highest returns possible, but such an approach comes with a lot of risk and will likely come with a lot of volatility. That’s why professionals spend lots of time attempting to construct portfolios with acceptable levels of risk-adjusted returns. What are reasonable levels of return that come with reasonable levels of volatility that won’t lead to the investor freaking out? That’s the name of the game, and it’s different for everyone based on their experience with investing and their emotional make up.
Why should we invest in bonds?
We’ve covered this to an extent, but it’s worth addressing in more detail before we conclude this guide. We’ve already addressed asset allocation, example portfolio designs and discussed things like risk-adjusted returns. A bond allocation is a relevant subject to all of these concepts. But the most interesting thing here is that investing in bonds is a very personal choice. If you look at a recent message board thread on the popular Bogleheads forum entitled “Why do you hold bonds in your portfolio?” you’ll notice a wide range of answers from very knowledgable investors.
The common answers from that thread are as follows:
- “Bonds give you some return and move in a narrower range than stocks.”
- “Easy question. My portfolio is 40 percent bonds so I don’t lose everything if stocks tank.”
- “Bonds are ballast to hedge risk.”
- “Bonds help me sleep better at night.”
- “I hold them so I can SWAN [sleep well at night]. And, I do.”
- “Because I don’t know what assets will outperform others in the future. So I hold a few different kinds (including bonds)”
- “Rebalancing and sequence of returns risk.”
- “We have a certain amount in bonds that we feel comfortable holding in case the stuff hits the fan. It’s enough to withstand almost anything.”
These answers fall into a few different buckets such as risk management or reduction of volatility, peace of mind, and diversification. I love looking at these answers because they come from real people who have essentially “won the game” in many regards. These people have successfully accumulated and built portfolios to retire on and life comfortably. They are well read and enjoy discussing investing. And lastly, they have varied opinions as you can see above. Some reasons are emotional and others are strategic. Neither are incorrect.
Understanding returns, standard deviation and Sharpe ratio
To properly navigate the allocation of a large sum of money – after all, the point of this article is to discuss how to invest 1 million dollars – it’s important that you take steps beyond the very simple basics of investing. You need to understand how risk plays a role and how this is measured in things such as standard deviation and Sharpe ratio. While this isn’t a comprehensive study of these concepts, it can serve to be an introduction to them and perhaps you can utilize other resources to dig in further as needed.
Standard deviation is a statistical concept that essentially measures how spread out a group of numbers are. If you have 10 numbers that are all either 8, 9, or 10, then another group of 10 numbers that range from 5 to 15, the standard deviation of the first group is going to be lower than the second group. The first group is not as spread out as the second group.
You can take this simple illustration to the investing world to understand how we measure risk with standard deviation. If you’re attempting to gauge how risky a stock is (or an entire portfolio) you can look at a series of return data points. If you’re looking over a long-term perspective, you might look at the annual return number for a set of 25 years. The standard deviation will tell us whether or not the returns over that period of time are pretty consistent or if they’re “all over the map.” If a stock returns -25% one year, then 75% another year, then 15% the next year, you’re going to have a large standard deviation, because the numbers are bouncing around quite a bit. Another stock might be much more stable and return anywhere from -10% to 10% every single year. This would be a lower standard deviation. Bonds, on average, have a much lower standard deviation because they trade in a much narrower range typically.
Conceptually, the goal is to build an investment portfolio that delivers reasonable returns without giving us wild swings every year. We want the highest returns possible with a low standard deviation. Easier said than done, but that’s the goal.
The Sharpe Ratio is a single measurement that attempts to take in considering volatility along with returns. It gives us the “risk-adjusted return” measurement of an investment or a portfolio. The simplified version of the Sharpe Ratio formula is simply average return / standard deviation. These returns might be daily returns or annual returns, for example. By dividing the average return by the standard deviation, it factors in the risk being taken here. Portfolio strategists will often work hard to develop portfolios and asset allocations that result in the highest Sharpe Ratio possible.
We hope this guide on how to invest 1 million dollars was useful whether you have a specific sum of $1 million to invest or not. Hopefully you have been able to learn more about asset allocation, risk, volatility and risk-adjusted returns. If you want to continue to learn how to invest 1 million dollars or save over time for retirement, consider reading these additional articles: