is an example taken from here. The graph plots points using assumptions for rates of return. What this graph doesn’t show you is how widely the results can vary from those expected numbers. Any one of those lines can be higher or lower than those expected amounts.
I haven’t seen a graph that adequately shows these ranges, but understand this, the farther you are on the left on this graph, the less that range tends to be.
The point anyone using this graph really wants you to see is the one farthest to the left that is associated with 75% bonds and 25% stocks. If you want your money to consistently go up and almost never go down, that is about where you want to be at.
Note how the returns are higher and the risks are lower than being 100% bonds, the option second closest to the left. A 50/50 split is next closest to the left.
The science of all of this is called Portfolio Theory. The idea is to choose an acceptable amount of risk and try to find the highest expected profit for that amount of risk. You can also take the expected profits and work backward to try to figure out how to minimize risk associated with it.
Note how much farther to the left the 70% stocks and 30% bonds line is compared to the 100% stocks line. That’s a lot less risk of loss compared to the 100% stocks line. It’s a good bit farther down on the returns line too, that’s the tradeoff.
When people flee stocks (after that risk has kicked in and the returns have gone below zero) they usually flee straight to bonds. The money they pour into bonds tends to make bond results go up. That is why that 70/30 line is a lot lower on risk than the 100% stock line is.
It’s important to determine where you want to be on this line.
If you are the type to want to minimize your likelihood of your account values ever going down from one year to the next, just pick the dot farthest to the left. A side effect of that is that that point also has the least variance of returns, meaning that you can use the returns you see there and project them forward in time with the most accuracy. By doing that, with that you can attempt to figure out how much money you need to save to reach your goals and other things.
If you try to do that with other points, you have a greatly higher chance of being wrong when you try to make projections into the future. The way around that is to just throw in more money and hope for the best.
Another important point to point out here is that if you try to give someone money and in return get a guarantee of getting more money back in the future, the place that the people who take the money are going to put it is the one farthest to the left.
An example of that would be permanent insurance. You pay the insurer some money to cover the likelihood of your death and any amount above that they invest in that point farthest to the left. That is how they can guarantee you a minimum gain of 4% every single year and their businesses can stay in operation for hundreds of years. It is exceedingly rare for an insurer to go out of business because their primary business is knowing how to invest money in the least risky way possible and they are very good at it.
Anyone who took money from you and did anything other than investing it in the farthest left point would just be gambling and they should prepare for the eventuality that they might need to pay you back out of money they took from somewhere else.