Asset allocation is more art than science. There are no immutable laws to tell you what proportion of stocks and bonds should be in your portfolio. The best you can do is adopt rules of thumb. “Make your bond allocation equal to your age” is a popular one, as is “Don’t invest in equities if you will need the money within five years.” In the end, it comes down to a trade-off between risk and expected returns.
I found a lot of useful insights on asset allocation in Larry Swedroe’s newest book, The Only Guide You’ll Ever Need for the Right Financial Plan
His new book is written for an American audience and most of the financial planning advice isn’t useful for Canadians. However, a large part of the book is devoted to asset allocation decisions, which should be based on “the ability, willingness and need to take risk.” Let’s break down these three factors.
The ability to take risk
Swedroe says your ability to take risk depends on your investment horizon and the stability of your income (or human capital). If you’re 25 years from tapping your savings, or if you’re a senior public servant, you can keep a large portion of your portfolio in stocks. If you’re three years from retirement, or if you’re a commissioned salesperson, you should hold a far greater proportion of fixed income investments.
Swedroe offers these guidelines when considering the right equity allocation for your investment horizon. You can increase or decrease these suggestions based on your income security:
| Your investment | Maximum equity | |
| horizon (years) | allocation | |
| 0–3 | 0% | |
| 4 | 10% | |
| 5 | 20% | |
| 6 | 30% | |
| 7 | 40% | |
| 8 | 50% | |
| 9 | 60% | |
| 10 | 70% | |
| 11–14 | 80% | |
| 15–19 | 90% | |
| 20+ | 100% |
The willingness to take risk
How likely are you to panic when your portfolio loses value, as it inevitably will? Is a 25% drop going to give you ulcers? The willingness to take risk depends on your psychological makeup. Advisors give their clients risk-tolerance surveys to measure this willingness, but these are only worth so much. Only real-life experience — and we just had a litmus test in 2008–09 — will determine how big a loss you can truly tolerate.
Here’s Swedroe’s guidelines for determining a portfolio’s equity allocation based on the degree of loss you can accept without hurling yourself out the window:
| Maximum loss | Maximum equity | |
| you’ll tolerate | allocation | |
| 5% | 20% | |
| 10% | 30% | |
| 15% | 40% | |
| 20% | 50% | |
| 25% | 60% | |
| 30% | 70% | |
| 35% | 80% | |
| 40% | 90% | |
| 50% | 100% |
The need to take risk
Finally, all investors should consider their need to take risk. If your financial plan suggests you’ll need a 7% annualized return for 20 years to retire comfortably, you’ll need a significant allocation to stocks. But if you’ve saved enough money to meet all of your financial goals, you might forgo all market risk. Swedroe tells the story of a couple in their 70s who had saved $13 million, only to lose $10 million by investing it all in tech stocks. The couple admitted that if their portfolio had doubled, it would have had no effect on their lifestyle or happiness. Why, then, did they put all that money at risk for no reason?
Swedroe doesn’t match specific asset allocations to target rates of return, which is smart, since no one can predict what the markets will give us in the future. However, in a previous post, I included a table of returns for different stock-bond mixes since 1970. Vanguard also publishes historical returns for several portfolio mixes going all the way back to 1926.
You may be surprised to see that a simple 50–50 portfolio has delivered long-term returns between 8% and 10% annually (depending which indexes you use and how often you rebalance). How many people need returns higher than that to achieve their goals? If you take more risk than that, make sure you have the ability and the willingness to stick to your plan.
{ 6 comments… read them below or add one }
Burton and Malkiel suggest allocations in Elements of Investing that I think would be useful to readers here – you may want to post them. They are not as conservative as the “Make your bond allocation equal to your age” though they do provide a table of more aggressive allocations and one that is more conservative.
Also, in true “set it and forget it” fashion, as someone in mid to late 30s, my rule of thumb has been to choose an allocation target and stick with it for defined set period of time. For my retirement portfolio that time is 5 years. So, on an annual basis I rebalance to this target until I am 40. At 40, I will revisit my allocation and bump up the fixed income portion and then revisit at 45, etc… For my RESP, I have chosen every 2 years as my defined set period of time. Without establishing this rule, I would fiddle too much with the allocation percentage.
@Greg: Good idea — The Elements of Investing is available as a free download at http://lto.libredigital.com/?VanguardTheElementsofInvesting. See pages 108 and 109 for their suggested allocations.
For the record, I think their suggestions are too aggressive, especially Ellis’s. He suggests 85% to 100% in stocks for people in their 40s, and up to 50% stocks beyond age 80. Ask some retirees how that would have worked out in 2008.
@Greg
Since you re-balance yearly I’m curious where you put your money for most of the year as you earn it.
I had a similar plan, but with the top savings account at 2% (Ally Canada) and money market funds being lower than that, it makes me wonder.
Recently I’ve made budget cuts so that I can trade more often to take advantage of the higher yields I’m already seeing in the market. With $4.95 trades at Quest Trade it wasn’t really much of a sacrifice (a couple World of Warcraft accounts and some beer
)
While I agree with the underlying principles, I find the allocation tables rather simplistic. Reality is much more nuanced. For example, someone may be one year from retirement (0% equity) and yet 20 years (100% equity) away from needing the 20th installment of yearly income.
@RMCH – My secret is that my employer has an RRSP match program and I use the retirement program they offer to hold on to my savings until I can transfer them and purchase my ETFs. Money is drawn directly from my pay and is put into mutual funds in a workplace retirement account. Because the MERs of these mutual funds are reasonable, I have no problems investing in them (that portfolio is split almost evenly between canadian fixed, canadian equity, US equity and Intl equity). Once per year I move these investments into cash and transfer my portion of the RRSP contribution to a discount brokerage where I invest in ETFs. For the portion of my workplace plan that I am not allowed to transfer, I have set that to automatically rebalance to my target allocations.
I only recently took control of my wife’s RRSP. We are using index mutual funds and dollar cost averaging. Not sure yet how I will rebalance that.
I believe Couch Potato recently had an article on using TD Balanced Index Fund (TDB965) to hold monthly contributions. You should check it out.
Basic question since you’ve made a big deal about risk and equities. “How do you define risk?”