According to Wikipedia – Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.
Figuring out the proper asset allocation is one of the most difficult challenges that a new investor has to face when she/he starts investing in the stock market. The main problem is that new investors don’t know their risk tolerance until they go through a few boom and bust cycles. Many of my friends started investing in the stock market in the late 90s right before the dot com bubble. When the bubble collapsed, a bunch of them sold off their investments at a loss and swore off stock investing for many years.
I know now that selling stocks in the middle of a bear market is a terrible idea. Young investors actually should look forward to a bear market. This is when you will be picking up the best deals and makes the most money. However, most investors can’t bear to add money in a down market and they usually sell off their stocks to feel safer. Young investors who should have high risk tolerance are actually the ones that have the least experience and don’t know how to handle a bear market.
Recently I stumbled across an interesting asset allocation article at Forbes. Rick Ferri talks about the flight path model asset allocation plan. (See image from Forbes above.) His proposal is that instead of starting off with high equity, young investors should start off with 40% equity (stocks) then ramp up to 70% by the time they are 30 years old. By starting off with less equity, a new investor will have less exposure to the volatility of the stock market. Hopefully this will prevent the cases like my friends who swore off stock market investing and missed out on the subsequent recovery.
I think this is actually a pretty good idea for young investors especially if they haven’t gone through a bad bear market yet. You might think your risk tolerance is high, but can you really stomach a 50% decrease in your investment portfolio? You won’t know until you go through it.
I would like to make a modification here though. Instead of investing in bonds when you’re young, I’d rather stash the money in CDs and saving accounts. When you’re young, there are many capital intensive goals like buying a house, having a kid, and taking international trips. You need cash for those goals. Having more liquidity is a good thing, but you need to have a lot of discipline too. It would be easy to blow $10,000 on a luxury car down payment when you’re in your 20s. 🙂
The other end of the flight path model is at the retirement age. Rick proposed a 40/60 stock/bond split throughout retirement. Now that people are living longer, we need more equity in our retirement portfolio than the previous generations. After 15 years of investing, I’m pretty comfortable with stock market investing and I probably will have some equity exposure when I’m 64. There are other factors though. If I have 5 million dollars at that point, then I can afford to be safer and go with lower equity allocation. My risk tolerance would probably change by the time I get to that age. We’ll see how it goes.
Investing in the stock market is volatile and a big bear market can scare off new investors. The one thing I learn is you can’t get scared off by the bear. You just have to stay the course and keep investing through the ups and downs. If you have 20+ years left until retirement, you will do fine if you just keep adding to your investment. The flight path model might help some young investors stick with the stock market and I think that’s a good thing. If you’re bullheaded like me, then you’ll probably be alright with the regular age base model. (Start off with high equity.)
Do you know anyone who sold off in the middle of a bear market and swore off investing? What do you think of the flight path asset allocation model?
Asset allocation is very personal and any model is just a guideline. It’s probably fine to get you started, but you will need to figure out your own plan. If you need help with financial planning, check out Personal Capital. If your portfolio is over $100,000 they will set you up with a free financial planning session. It’s nice to review your portfolio and figure out a plan for the future.