Asset allocation is a blend of art and science. You will find that there are no immutable laws to tell you the proportion of equities, property, bonds and cash that you should hold in your portfolio.
Now, you may have heard some rules of thumb (“make your bond allocation equal to your age” is a popular one), but there are so many exceptions to the rule that they really are not helpful for most investors. At the end of the day, your asset allocation decisions come down to your comfort with the balancing act of risk and expected returns.
Larry Swedroe, who writes the Wise Investing blog at CBS MoneyWatch frames it well. He says that asset allocation decisions should be based on your “ability, willingness and need to take risk”.
The ability to take risk
Your ability to take risk depends on several factors: your investment horizon, the stability of your income (or human capital) and your other sources of income. For example, a 35 year old manager is unlikely to tap into her super savings for another 25 to 30 years, so can keep a large proportion of her portfolio in equities and other growth assets. Equally, a 60 year old senior public servant with a healthy defined benefit pension scheme, can also keep a large portion of his portfolio in shares. On the other hand, if you’re a 60 year old executive with five years until retirement, or a 35 year old entrepreneur, we would suggest that you may want to hold a greater proportion of fixed interest investments.
The willingness to take risk
How will you respond when your portfolio loses value, as it inevitably will? The answer will shape how much of your portfolio you should hold in growth assets like equities.
Your willingness to take risk depends on a range of factors: your value around financial security and stability, your psychological makeup, the amount of money you are investing and your experience with investor.
We talk to clients about their willingness to take risk in terms of how much in dollar terms they are prepared to see their portfolio fall (on paper) without panicking. Would it take a one-third loss before you panic? If you have a million dollars, that’s a $330,000 drop. Or would just 10% – $100,000 loss – give you ulcers?
The need to take risk
Finally, all investors should consider their need to take risk. If you need a 7% year return for the next 15 years to retire comfortably, then you’ll need a significant allocation (around 60%) to growth assets. If you’ve reached your target and have enough money to meet all of your financial goals, you might forgo all market risk – regardless of whether you’ve got 15 months or 15 years time horizon.
What is the lesson for investors?
So what is the lesson for investors? There are a couple.
First, don’t make the mistake of investing more aggressively than you are able, willing, or need. Many super default funds, although they’re called ‘balanced’ have more than 70% of their asset allocation in growth assets. In a major downturn, that could mean a 35% to 40% capital loss.
Second, asset allocation is not “set and forget”. The behaviour of asset classes changes over time – for example, in the past five years we have experienced unusually low market volatility. And your own circumstances, ability and willingness to take risk may also change over time.
Now is a good time to re-frame your investment strategy. This is because we are in a period of low volatility and positive returns – which means you are more likely to be feeling calm and rational. So if you’ve been procrastinating about dumping your high-cost active funds, investing that idle cash, or adjusting your asset allocation to keep it in line with your goals, then now might be a good time to do that.
Because when a storm hits again—and it will, though no one knows when—any changes you make are likely to be based on fear and emotion. And we all know how that works out, don’t we?