Asset allocation: An investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
Whew, that was a little slice of Snoozeville. I will try my best to make the rest of this article a little more interesting… Asset allocation may sound very boring, but it is essential for long term investing. Your asset allocation is your investment road map. It will point you in the right direction and bring you back on track if you go astray.
Generally, there are 3 asset classes that are included when we work on asset allocation.
- Stocks – This could be individual company, mutual fund, and/or ETF. The stock market has the highest risk/reward out of these asset classes.
- Fixed income – Bonds, bond funds, and Certificate of Deposit. This asset class is much safer than stocks, but historically generate less ROI.
- Cash – Money in easily accessible accounts such as a saving account or money market.
Most of us like the gain from stock market investing, but we also can’t really handle the volatility. We can reduce volatility and risk by investing in bonds and having some cash reserve. Having some bonds and cash will also let you buy stocks during those down markets.
I think it is perfectly fine to put everything in stocks when you are just starting out and don’t have much money. As you get older and your life situation changes, you will need to adapt your asset allocation accordingly.
Asset Allocation will change as you age?
I invested all my portfolio in the stock market for many years, but now I’m much more diversified. What changed for me?
Goals – We all go through different life stages. When we first start working, our goals might be just to have fun. Later on, it might be to buy a house, to fund your kid’s education, or save for retirement. All these different goals will alter your asset allocation. For me, I’m not working a full time job anymore and I can’t save as much as previously. My goal now is growth with a big dose of capital preservation thrown in.
Risk tolerance – As you get older and build up a bigger portfolio, your risk tolerance will most likely decrease. When I was young, a 30% drop in the stock market didn’t faze me (much) because 30% of my portfolio was just $10,000. Now, I’d be physically sick if our portfolio dropped 30% because the raw dollar amount is so much bigger.
Investment horizon – As you get older, you also have less time to recover from a huge loss. If you are withdrawing living costs from your portfolio, a big down year have an equally big aftershock. All the money you withdraw during a down year will not have a chance to be a part of the economic recovery. Most older people also like more stability in their portfolio even at the cost of long term return. Our investment horizon is still about 20 years so we can be more aggressive right now.
How to dial in your asset allocation
It’s important to find the right asset allocation for yourself and stick with it through thick and thin. A lot of individual investors lost a lot of money by selling at the wrong time. If you have a personalized asset allocation plan, then you won’t have to worry about trading in and out of the market. You just need to stick with it and rebalance once in a while.
However, finding your own custom asset allocation ratio is not easy. I think it takes at least 10 years of investing to know how much risk you can tolerate. When the stock market is doing well, everyone’s risk tolerance is sky high. Who would want to miss out on the 20% gain on VB (small cap index ETF) we have seen in 2013? The real test will be when VB drops 50%. Go through a few of these down markets and you’ll see how much risk you can really handle.
Asset Allocation Calculators
Luckily, there are many online calculators to help you dial in your asset allocation. If you have been investing for less than 5 years, I would go through at least a few of these just to see what they say. You are probably overestimating your risk tolerance quite a bit.
Vanguard Investor Questionnaire. The Vanguard questionnaire asks you ten questions in an attempt to determine your risk tolerance. After you answer the question, Vanguard will show you the recommended asset allocation. I like this one because it’s pretty simple and it will show you Vanguard’s recommendation. Their recommendation seems a little conservative to me though.
This quiz from Yahoo! has 10 questions – Over 90 percent of investment returns are determined by how investors allocate their assets versus security selection, market timing and other factors.* Use this calculator to help determine your portfolio allocation based on your propensity for risk.
* Source: Brinson, Singer, and Beebower, ‘Determinants of Portfolio Performance II: An Update,’ Financial Analysts Journal, May-June 1991
Investment Risk Tolerance Quiz from Rutgers - Answer 20 questions in an effort to determine your risk tolerance level.
Here is what I got from Rutget – Your Score: 33
You have a high tolerance for risk.
Once you have a ball park for your risk tolerance, you can plug it into these other asset allocation calculators below as well.
- CNNMoney: CNNMoney steps you through four questions designed to figure out what kind of risk taker you are. It then generates a fairly basic asset allocation mix.
- SmartMoney – Input your info and see their asset allocation recommendation.
- Bank Rate’s asset allocation calculator – input your age, asset, savings per year, and a few more things to see the recommended asset allocation.
Get some professional help
The asset calculators are a nice start, but you’d probably want to talk to a real live financial advisor at some point. This is another whole topic which I don’t have much experience with. Here is a financial advisor’s article from Get Rich Slowly that’s helpful.
Another good option is to try Personal Capital. If your investable assets are over $100,000, then they will help you analyze your investment and come up with a personalize asset allocation plan. I had a financial planning session with Michelle CFP at Personal Capital and it was quite helpful for me. This is a great option if you want someone to take an in depth look at your risk tolerance and portfolio. You can also hire Personal Capital to manage your entire portfolio if you’d like. I wanted to continue managing my portfolio and they asked me to keep them in mind in the future. It was very nice that they didn’t try to do a hard sell on me.
Here is my personalized recommendation. It’s quite detailed and it’s very helpful.
Work on your asset allocation
It’s essential to find your optimal asset allocation plan. It will keep changing as you get older and gain more experience, but the earlier you start, the better off you’ll be. A customized asset allocation plan will guide you through those rocky years.
Do you have an asset allocation plan? Has it changed much over your investment life?
Follow up - Early Retirement Investing 101: Rebalance Your Portfolio