Best Asset Allocation Based On Age & Risk Tolerance
How To Figure Out the Best Asset Allocation For You
Graham from Moneystepper asks;
What metric (rule of thumb) would you recommend for asset allocation based on age and risk appetite?
Graham’s question is not as simple as it might seem. Let’s attack it from several investment angles and throw in a bit of research as well.
Quick Primer: What Is Asset Allocation?
The asset allocation decision divides total investable funds by percent into specific investment categories. An asset allocation represents the investor’s choice of broad asset classes and the percentages distributed across the categories.
The two most common asset classes are stocks and fixed, which includes bonds and cash.
Based upon the seminal study by Brinson, Hood, and Beebower, “Determinants of Portfolio Performance”, from the August 1986 Financial Analysts Journal, asset allocation is widely considered the largest contributor to a portfolio’s return.
In other words, the individual stocks, bonds, and funds you choose or when you buy or sell is less important to your ultimate return than the percent allocated to various asset classes. That still doesn’t answer the question, “What is the best asset allocation for you?”
If you invest in a diversified mix of 50% in stocks and 50% in bonds, your return will closely approximate the market return of 50% stocks and 50% bonds.
Asset allocation is very important because it creates portfolio diversification and reduces an investment portfolio’s risk.Click here for top notch beginning – advanced investing courses.
Adjust the Classic Asset Allocation Advice
The classic asset allocation advice is very simple:
Take your age and subtract it from 100. Then invest the resultant percent in stock assets with the remaining percent in fixed assets.
If you are 40 years old, according to the classic advice, you should have 60% in stocks and 40% in fixed assets. Like the graph above. (100-40 years old=60% stock assets)
We’re living a lot longer than in the past. That’s why the updated idea is to subtract your age from 120 and use the remainder to invest in stocks.
If you’re 50 years old, subtract that from 120 and you’re left with 70. So the new thinking suggests a typical 50 year old should have 70% of her assets in stock investments and 30% in bonds.
This advice is a good starting point, but incomplete.
Know Your Risk Tolerance
The historical wisdom suggests that if you are young, with many working years ahead, you are more risk tolerant. This theory goes on to imply that if you suffer a big loss in your investment portfolio at age 30, you have many working years ahead to replace the lost funds. Thus, younger investors are typically advised to own more stocks and less bonds since stocks offer the prospect of greater long term returns (albeit with more risk).
What happens when the market tanks?
Your portfolio = 70% Stocks and 30% Bonds
Imagine this scenario, it’s the end of 2008, you are 30 years old and your investment portfolio holds 70% stock mutual funds and 30% bond mutual funds. Your stock funds fall 33.8% (Dow Jones Average 2008 loss), the worst drop since 1931, according to an ABC News report. (And if you were especially unlucky, your General Motors stock fell 87.1%.)
2008 is an example of stomach churning investment losses.
Fortunately, the bond portfolio (proxy; Barclay’s aggregate bond index) returned 5.24% in 2008.
Thus, if you invested 70% in a Dow Jones index fund and 30% in a diversified bond index fund, your return in 2008 would have been; -22.09%. ((.70 x -.338) + (.30 x .0524))
If you had a $25,000 portfolio on January 1, 2008, on December 31, 2008 the value would have fallen to $19,478. In 2008, $5,522.50 of wealth would have vanished in one year.
Although a 22% loss isn’t great, it’s a better return than that of an all stock portfolio.
Had your stock fund been invested in a broader market index, the Standard and Poor’s 500 in 2008, your stock allocation loss would have been a whopping 36.55%.
Consider a ‘worst case scenario’ and do a gut check.
Regardless of your age, if you are extremely risk averse and cannot tolerate drops in your portfolio value, you may want a greater percentage in fixed/bond assets and a lesser percent in stocks.
Michael Kitces, a well known investment advisor and prolific writer alleges that risk tolerance is stable and can be measured. He recommended in a blog post as well as a recent twitter exchange, a risk assessment tool at Finametrica (free trial available). Index Fund Advisors also has a risk quiz I’ve tried (be prepared for a quick registration and follow up phone call).
If you want a quick and easy risk tolerance measure, try my (non-scientific) Sleep at Night Guide to Risk:
Your age does not necessarily correlate with your risk tolerance.
Many younger folks cannot handle all but the smallest declines in their investment portfolios. Thus, the more risk averse investors need a greater percent in fixed assets.
What Is the Best Asset Allocation Based On Age and Risk Tolerance?
The best asset allocation for you should consider your age, risk tolerance, how long you expect to work (your human capital) as well as where you work. If you work in the investment industry, you may want to direct a lower percent towards stock investments. That’s because your job is dependent upon the financial markets. You do not want to experience a drop in your stock portfolio and a layoff because the market tanked.
If your income is erratic or uncertain, be sure to ramp up your cash investments.
Asset Allocation Action Steps
1. Spend a bit of time understanding yourself and the markets. If you’re interested in an excellent 100 page book on investing, I recommend The Elements of Investing, by Malkiel and Ellis.
2. Take a risk tolerance quiz and assess how you will feel when your portfolio experiences an inevitable cyclical decline.
3. Create an asset allocation considering your age, risk tolerance, security of your job, and industry. If you’re job is insecure, you want lesser amounts in stocks and bonds and more in cash assets.
4. For more on this topic, click the link to read my free ebook: How to Invest and Outperform Most Fund Managers.
What is your age and asset allocation?
A version of this article was previously posted, comments remain.