Asset allocation is an important component to any portfolio. It deals with the ratio between various asset classes such as stocks and bonds. Many investors don’t know where to start or how to determine if their asset allocation is appropriate based on their objectives or risk tolerance. Below are four strategies to determine an appropriate asset allocation. Each one with pros and cons.
- Rule-of-thumb Formulas 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. But an investor’s risk profile is not static. It changes day to day, depending on their 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, his allocation shifts to more conservative asset classes. This can help reduce the risk of extreme market volatility right before they enter 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 factors he/she would take on to try to reach that goal. This often sparks a conversation with the client about other factors that should be explored, such as increasing the savings rate or adjusting the goal.
If you’re looking to get started, begin with this popular rule of thumb: subtract your age from 110 to determine your stock percentage, put 10% in cash, and the remainder in bonds. From there, you can edge the portfolio to be more aggressive by increasing your stock holdings or more conservative by increasing cash or bonds.
This is starting point, although you should seek professional guidance in determining an asset allocation that will meet your objectives.