How Much Risk Should you Take? Part 2

Asset Allocation: Part 3

If a questionnaire isn’t going to cut it when it comes to determining your asset allocation, what is?  As I hinted at last time, for the vast majority of people it’s going to be your age and life situation.  There are, however, a few things we need to consider first.

 

1.     Education.  This is really foundational because without the proper set of facts you may be much more willing to make a rash and dumb decision in the heat of the moment.  However, as long as you know the truth and remember it during tough times it should make it pretty easy to stick through whatever is coming your way.  Knowledge really is power and the simple acting of understanding reality can do wonders for adjusting our behavior.

So just remember….If you hold your investments for a long period of time and don’t do anything stupid in the meantime, you will make money.  In any 10 year period since the Great Depression, the stock market has only lost money 1 or 2 times.  In any 15 year period the stock market has never lost money.  So, if you are in it for the long term you can be pretty certain you will make money.  I also recommend you check out John Bogle’s Little Book on Common Sense Investing as a good stating point for your investment education.

2.     Emotion free decisions.  This goes along with education but if we allow our emotions or moods to rule our decisions we will be much less able to make a rational one.  We must be willing and able to step outside of ourselves and look objectively at our situation.  This really isn’t that hard for most people.  Or at least it doesn’t have to be, especially once they get the education piece.

3.     Temperament.  I hesitate to put this one in because it is so hard to determine (It is one of the main things the questionnaires try to answer).  For the majority of people a little bit of education and reassurance is all they will need to stick to their chosen plan no matter the market.  However, if you know that you absolutely cannot handle the risk of losing money then your portfolio should be much more heavily weighted towards bonds than stocks.

Assuming you have the above 3 taken care of, it is time to look at the best way to divide up those assets.  And for this we will also break it down into three things to consider:

  1. Age
  2. Financial Situation
  3. Who will be using the money
According to most of the people I look up to and read, people like John Bogle, Burton Malkiel, Rick Ferri and others, age is the primary factor in determining an asset allocation and risk tolerance strategy.  The theory goes something like this, “The younger you are the more risk you can stomach.  The older you are the less risk you can stomach.”  I really like this approach because it is dealing in facts, not conjecture.  Since one of the main things with investing is ensuring your money doesn’t run out when you need it, as we get closer to retirement we should be increasing our exposure to less risky investments, such as bonds.  Our age is a great barometer to help us do that since it is directly correlated with our retirement date.

The second factor is financial situation.  If you are actively drawing from your investments, you should have much less risk in your portfolio than someone who is actively saving.  This is outside of the normal withdrawals that occur during your retirement.  An allocation based on age will take care of that.  If you are prior to retirement age and are dependent on withdrawing from your investments for any reason, you should consider weighting more heavily toward bonds to minimize the risk of a major down cycle as you are withdrawing.

The last factor is who will be using the money.  If you will be using the money during retirement then as you get closer to it you should get more conservative with your portfolio.  If you are investing the money for your kids or grandkids you should take that into account and use a strategy suitable for them, not you. In those situations you should use the beneficiaries age, not your own.

Ok, now we know age is what we are using barring a unique situation.  But what does that look like practically.  

There are a couple of options:

  1. Age in Bonds
A common way to think about the age factor is to have your age in bonds.  If you are 30, you have 70% equity, 30% fixed income.  If you are 50, you have 50% fixed income.

  1. Age – 10% in Bonds
Another variant is your age -10% in bonds if you want a little more equity exposure.  If you are 30, you have 20% in bonds, if you are 50, you have 40% in bonds.  If you are more conservative by nature another variant of this would be to do your age + 10% in bonds.  

(Remember when doing this to use the age of the person who will be using the assets, whether that is you, your child or your grandchild.)

In the Elements of Investing, Burton Malkiel provides this helpful guide that should work for the vast majority of investors…
 

Whichever way you choose to go with your own asset allocation, use the age factor as a baseline to anchor you and then adjust accordingly.

This is a much better approach than trusting a biased survey whose answers have no better chance of predicting your behavior than you do of predicting the market.

Please note: I reserve the right to delete comments that are offensive or off-topic.

Leave a Reply

Your email address will not be published. Required fields are marked *