There are four ways to determine an appropriate asset allocation. Each one with pros and cons.
- Rule-of-thumb formulas. These are useful for quick planning purposes. For an investor, this should be a starting point to see if their current allocation is in the ballpark.
- Risk Tolerance. Investors can complete questionnaires which can identify how comfortable they feel about volatility in their portfolio. The questions identify how the investor would feel if they were to see their account value decline by X% over various time frames. Based on their answers, a portfolio is designed around their risk profile. This is an objective data driven solution, which many find appealing. Unfortunately, an investor’s risk profile is not static. It changes day to day, depending on life experiences, the news, and a variety of other factors. When the economy has a negative outlook, an investor’s appetite for risk is usually much lower than when the economy is bullish.
- Stage of Life. Age-based asset allocations that adjust over time have grown in popularity. The premise is simple; as an investor gets closer to retirement, their allocation shifts to more conservative asset classes. This can help avoid periods of extreme market volatility right before entering retirement. The downside? this approach does not factor in personal considerations such as risk tolerance, longevity or financial goals.
- Goal based. At times, we have built portfolios around a client’s financial goal, such as having $500,000 in assets by the time they retire. We can show the client the risk profile they would take on if they wanted to try to reach that goal. This is often used to spark conversation with the client about other factors that should be explored, such as increasing the savings rate or lowering the goal.
Bottom line, there is no single solution on how to arrive at an appropriate asset allocation. A combination of some or all may be appropriate. Maybe an investor uses the Stage of Life Approach and tilts it more aggressive or conservative depending on their specific risk tolerance.
Contact us for a free consultation to help you build your asset allocation.