Asset allocation accounts for 88% of your investment experience, according to Vanguard research. That means if you have a diversified portfolio, your investment returns will be nearly identical to those of another investor with an equally diversified portfolio in the same asset allocation bucket. It doesn’t matter what individual investments you choose.
Given how important it is to your investing outcome, you want to get your asset allocation right. A common guideline among investors is to determine your asset allocation by age. For instance, one rule of thumb says 100 (or, more recently to compensate for longer lifespans, 120) minus your age should equal your allocation to stocks. The problem with rules of thumb is everyone’s thumb is a different size.
The truth is there is no asset allocation prescription for every 35 year old or every 50 year old. You and your life are too unique to lump you into a generic category based solely on your age. More important to asset allocation than your age is how long you have to reach your goal and your willingness and ability to take risk with your investments.
How Age Affects Asset Allocation
Asset allocation and age are related in a way. “From a financial planning perspective, our lives are a process of transforming human capital – i.e., our ability to do work and (earn) income – to financial capital in the form of savings,” says John Cunnison, a chartered financial analyst and vice president and chief investment officer at Baker Boyer. “Early in this process, most of us have lots of human capital, but not a lot of financial capital.”
When you are young, your steady income is like fixed income, or a bond that pays regular interest. You are your own bond, as Cunnison says, but are light on stocks, so almost all your savings should go into stock investments.
“As we age, we have fewer years to earn income, and our human capital decreases,” he says. “At some point, we will have enough stock, and we’ll begin to buy actual bonds to build a diversified portfolio that complements our human capital.”
This is partly why the guidelines say to shift your allocation from stock to bonds as you age. But you shouldn’t change your allocation simply because you hit your 40th birthday.
A Better Way Than Age to Determine Your Asset Allocation
Your asset allocation should be driven by four things: your time horizon, your ability to take risk, your willingness to take risk and the size of your financial goal.
Your time horizon is how long you have to reach your goal. This, rather than an investor’s age, is the critical factor for determining an appropriate asset allocation, says Andrew Crowell, vice chairman of wealth management at D.A. Davidson. The further you are from your goal, the more investment risk you can afford to take to reach that goal, which translates into a higher allocation to stocks.
Investment allocations by age are actually generalized forms of time horizon-based asset allocations. “Generally speaking, the younger an investor is, the more time they have to ride out the swings of the stock market and allow the power of compounding interest to work to their advantage,” Crowell says. Since stocks have historically provided higher total returns than bonds, “it stands to reason that a young investor would benefit from a larger exposure to stocks over bonds as they begin their savings.”
But this only works if the goal you’re saving for is many years in the future. A 28 year old who is saving to buy her first home in three years should not keep her home savings in stock. In this case, she is more like a retiree investor who has less time to recover from a market drop.
“In this latter case, a more balanced allocation with greater exposure to bonds would be preferable,” Crowell says.
If our 28 year old is saving for retirement in 30 years, however, she can afford to take more risk and use a stock-heavy asset allocation – if, and this is the big if, she can tolerate that much risk.
Ability to take risk and willingness to take risk are not the same, Cunnison says. While a young investor with a long time horizon and regular income can afford to take risk, if she gets nauseous at the sight of her portfolio’s value dropping and wants to sell at every downturn, she may not be willing to take that much risk.
“It is very important to avoid a situation where an investor panics because the volatility of their portfolio was too great,” Cunnison says. “This can result in the investor selling when the market is down, only to miss the subsequent recovery.”
You need to find the asset allocation that is appropriate for your time horizon but does not exceed either your ability or willingness to take risk. You should also never take more risk than you need to reach your goal.
If your goal is to buy a $10,000 Bengal cat in 20 years, you may not need to be 80% in stocks. In fact, if you can save $42 every month for those 20 years, all you’d need is a savings account yielding 1% per year to reach your goal. There’s no point in risking your savings on anything more aggressive if a conservative investment will do the job.
How to Determine Your Asset Allocation
Choosing your asset allocation does not need to be a complex, math-intensive process – but it can be if you have the wherewithal or support to do it. A financial advisor would be glad to help you optimize your asset allocation using financial planning software and simulation tests. And if you have access to an advisor, it’s certainly worth seeing a professional.
If you do not have access to an advisor, however, you can take a more generalized approach to asset allocation. Start by determining how long you have to reach your financial goal. If your goal is more than five years away, you can generally lean heavily (as in 80% or more) on stocks – assuming that much volatility won’t give you heart palpitations.
If you find yourself unable to sleep at night because your investments are jumping up and down, then back off your stock exposure. Instead of 80% stocks, try 75%. If you’re still anxious, try 70%. Keep working backward until you reach a level that lets you sleep at night but stay invested.
Original source: U.S.News