This is a guest post by Mike Smith. Mike is an electrical engineer with a passion for personal finance. He is the author of the personal finance and investing blog Richer by the Day, as well as a daily contributor to the Lending Club blog.
Asset allocation is an important part of portfolio planning, but it can also be rather difficult. There are a variety of methods that can be used to determine an appropriate allocation that I cover below, but first I wanted to discuss why so many of us discount proper allocation.
Poorly Allocated Portfolios May Still Gain Over Time
Many younger investors place too little emphasis on proper allocation because they tend to have such a long time frame for their investments to perform, whether we’re talking about retirement accounts or even taxable non- retirement investments. The fact that even poorly allocated portfolios may grow over time lulls us into downplaying the importance of proper allocation. We shouldn’t just be happy to make money, we should aspire for the best returns for our risk profile.
So how can we find the ideal allocation? Here are three common methods, complete with their benefits and limitations:
The 120 Rule of Thumb
The old rule of thumb was that retirement portfolios should have a percentage of stocks equal to one hundred minus your age and the rest in fixed income or stable value investments like bonds. More recently, this rule was updated to one hundred and twenty minus your age as people lived and worked longer. The fact that a rule of thumb needed to be updated is the first sign that it might be overly simplistic. Should younger workers use 150 minus their age to account for a potential update in the future?
The real trouble with rules of thumb in general, and the 120 minus your age rule specifically, is that while they might provide a general ballpark of what you should do, they aren’t tailored to your specific needs. You can imagine how differently I, a hyper-saver hoping to retire by age 45, would allocate my investments compared to someone else my age who plans to work until age 62-1/2 or beyond. Yet the 120 minus age rule would advise us both of the same allocation. Other problems include the non-linearity of allocation over time and the fact that there’s a whole range of sub-allocation within the different investment classes not addressed by this rule.
An improved allocation method over the simple rule of thumb is to use a lifecyle fund (also known as a target date fund). But these too have their limitations. The basic idea behind such funds is that you tell them the critical date of a future event and they’ll handle the allocation for you. So if you plan to retire in 2045, you might choose a lifecycle 2045 fund. Or if your first child was going to start college in 2030, you could use a 529 plan with a 2030 fund option.
As you might imagine, the funds would be more heavily invested in equities at the beginning and then slowly shift towards lower risk investments as the target date approached. These portfolios also tend to be automatically rebalanced to account for over- or under-performance of a particular allocation. The main problem with lifecycle funds is that the investments are out of your control. What you gain in ease of allocation, you may lose in control and investment choices. The major decline in the markets over the past year has also exposed another possible downside of such funds: if they are a little too aggressive near the target date you may be left with insufficient funds to cover your expense.
Financial advisers may feel insulted to be grouped in with web based asset allocation calculators, but the two approach the problem in much the same way. Both try to get a better understanding of your investment goals, risk tolerance, and extenuating circumstances before advising a particular allocation. Factors like my desire to retire at 45 would almost certainly be picked up by each method. Whether to meet with an adviser or use an online calculator is largely a matter of personal preference. If you are looking solely for an answer about allocation, then an online tool may suffice. If you want other financial advice also tailored to your specific needs, then you may be planning to meet with an adviser anyway, in which case allocation is a natural addition to your discussions. When determining your tolerance to risk, try to do so from a long term perspective. Many of us are biased by recent history, taking too conservative an approach when investments have been struggling of late and too aggressive of one after a positive stretch.
Once you determine an appropriate asset allocation, it’s important to revisit your choice on at least a yearly basis. Your desired allocation probably won’t change too much on such a short term basis, but your implementation of those investments almost certainly will. At that point you can re-balance existing investments back to your desired allocation, or adjust future investments appropriately. To see the importance of re-balancing, consider someone with a simplistic allocation target of 70% stocks and 30% bonds. After the roughly 45% decline in the general stock market over the past 16 months, their portfolio would now have 56% in stocks and the rest in bonds. The could either sell some bonds and buy some stock to get back to their target allocation or shift future investments exclusively to stocks until the desired allocation was again achieved.
Remembering the importance of asset allocation won’t guarantee outsized returns, but it will help to align your performance with your goals and tolerance for risk. Taking the time to find and execute the proper asset allocation is well worth the effort and may make all the difference in your portfolio meeting your investment objectives over the long term.
Jeremy’s Comment: I want to thank Mike for this guest post, but I also wanted to take this post one step further. Given the unraveling of the markets over the past year or so, many people have suggested that the rules of the game have changed. You hear things about how buy and hold doesn’t work, or asset allocation proves ineffective in major downturns.
So, I want to open it up to the readers to see what your feelings are. Have the rules really changed or are we simply being swayed by current events? Are the rules of thumb that worked for decades in the past no longer valid? I’m interested in hearing what you have to say.
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