Giving advice on asset allocation is one of the toughest things a financial advisor can do. How are they supposed to know how much risk another person can take? Asset allocation is an investment strategy that aims to diversify one’s portfolio holdings based on risk tolerance and time frame. Riskier assets generally include stocks and real estate while bonds and cash are referred to as safer investments. Risk and rate of return are always proportional, so while bonds and cash may offer you the most security, they often have the lowest rate of returns.
Choosing an asset allocation can be as simple as a rule of thumb: Hold your age in bonds and 100 – your age in stocks. Or it could involve an in-depth analysis of your long term financial goals and risk tolerance. My asset allocation is on the riskier side at 90% stocks, 10% bonds because I am looking at a 40+ year time frame before I plan to retire. Now is a great time to assess your risk tolerance because the market has seen almost a 10% drop in the past month. A combination of European debt woes and a dismal May jobs report in the US has really hammered my 401k. Let’s find out if you need to re-assess your asset allocation.
AA Provides Diversification
In the past month, the stock portion of my asset allocation has gone down nearly 10% while my bond fund has gone up 1%. Stocks and bonds are the two main components of my asset allocation because they don’t share a high rate of correlation. You want a portfolio with investment classes that do not move in the same direction at the same time to reduce volatility.
A diversified portfolio helps lower your overall volatility. Stocks have averaged around 10% annual return since the market’s inception, but some years have been better than the others. In just the past 20 years, we’ve seen a high of +33.5% in 1995 and a low of -33.8% return in 2008. These wild shifts in return are what’s known as volatility. Holding asset classes like bonds and cash will help to reduce your volatility.
Why is AA Important?
I advocate an 80-90% stock allocation for younger investors because they have such a distant time horizon for investment. 80-90% stock allocation isn’t risky when you are dealing with a time period of 40 years IMO. However, it’s important that investors feel comfortable with the risk they take on. This will allow them to ‘stay the course’ without panic selling during bear markets.
As you grow older, your AA should shift towards more conservative asset classes like bonds, or even cash. You want to maximize the chance that the money will be there when you need it. For immediate needs like real estate purchases, you should have your money in a liquid asset like cash or a CD. Asset allocation can get very complicated, but the basic principles stay the same no matter what your age is. A recently retired investor won’t want to change to 100% bonds because they will still be drawing from their retirement funds over the next 15-25 years.
A Final Word
In order to take advantage of future stock market gains, investors have to be comfortable enough to stay the course when their portfolio’s value starts to drop. The worst thing you can do during a bear market is sell your stocks because your portfolio was too risky. There’s not much a financial advisor can do during a time like this other than tell them not to panic. We have seen the market recover time and time again. Take a second to review your retirement portfolio and decide if you can handle a 10, 20 or even 30% drop in value. If you’re like me, this won’t bother you because you know you have such a long time before retirement. But if this scares you, you may want to consider investing in a more conservative portfolio.
Readers, do you know what your asset allocation is? Are you comfortable with a highly allocated stock portfolio or do the ups and downs of the market cause you to lose sleep?
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