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Asset Allocation and Risk Tolerance

The following is an adapted excerpt from the 2012 edition of Investing Made Simple.

When putting together a portfolio, the first thing to decide is your desired asset allocation. That is, how much of your portfolio should be invested in each asset class (e.g., U.S. stocks, international stocks, and bonds)?

Your asset allocation should be determined by your tolerance for risk. In turn, your tolerance for risk is determined by:

  1. The degree of flexibility you have with regard to your financial goals, and
  2. Your personal comfort level with volatility in your portfolio.

Financial Flexibility

Example 1: Jason is a construction worker. He’s 57, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered—but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.

Example 2: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $50,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $50,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a greater ability to take risk.

Comfort with Volatility

Your risk tolerance is also affected by your comfort level with volatility. One way to estimate this comfort level is to ask yourself, “How far could my portfolio fall before I started losing sleep, feeling stressed, or wanting to sell everything and move to cash?”

When answering this question, be sure to answer both as a percentage and as a dollar value—otherwise you may come to inaccurate conclusions. For example, you may remember that at age 25 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 10-times the size that it was at age 25, a 40% loss could be an entirely different experience.

When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative for your tastes, you’ll only be missing out on a relatively small incremental return.

In contrast, if you end up with a portfolio that’s too aggressive, you might end up panicking during periods of high volatility. Even one instance of getting out of the market after a sharp decline can be more than enough to eliminate the extra return you were hoping to earn from having a stock-heavy allocation.

Stocks vs. Bonds

Once you have an idea of your risk tolerance level, it’s time to move on to the first (and most important) part of the asset allocation decision: your stock/bond allocation.

One rule of thumb that serves as a reasonable starting point for analysis is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, said differently, assume that your stocks can lose 50% of their value at any time.

The most important thing to remember with asset allocation guidelines, however, is that they’re just that: guidelines. For example, with regard to this particular rule of thumb, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

U.S. Stocks vs. International Stocks

It’s not terribly surprising to learn that the U.S. stock market isn’t the best performing market in the world every single year. In fact, it’s often not in the top 10.

The difficulty in international investing—as with picking stocks or actively managed mutual funds—is that it’s nearly impossible to know ahead of time which countries are going to have the best market performance over a given time period. The solution? Own each (or at least many) of them.

The primary goal of investing a portion of your portfolio internationally should not be to increase returns, as there is no guarantee that international markets will outperform our own. Rather, the primary goal is to increase the diversification of your portfolio, thereby reducing your risk.

In total, the U.S. stock market makes up roughly half of the value of all of the publicly traded stocks in the world. However, most investment professionals recommend allocating more than 50% of the stock portion of your portfolio to domestic equities. Why? Because investing internationally introduces an additional type of risk into your portfolio: currency risk.

Currency risk is the risk that your return from investing in international stocks will be decreased as a result of the U.S. dollar increasing in value relative to the value of the currencies of the countries in which you have invested.

Simplified Example: A portion of your portfolio is invested in Japanese stocks, and over the next five years it earns an annual return of 8%. However, over that same period, the yen decreases in value relative to the dollar at a rate of 3% per year. Your annual return (as measured in dollars) would only be 5%.

So how much of your portfolio should be invested internationally? There’s a great deal of debate on this issue, with investment professionals recommending that you hold anywhere from 10% to 50% of the stock portion of your portfolio in international stock funds.

The trick is that without knowing how the U.S. market will perform in comparison to markets abroad, there’s simply no way to know what the “best” allocation will be. In my own opinion, allocating anywhere from 20% to 40% of the stock portion of your portfolio to international index funds would be reasonable for most investors.

Rebalancing

No matter how perfectly you craft your portfolio, there’s little doubt that in not too terribly long, your asset allocation will be out of whack. The stock market will have either shot upward, thereby causing your stock allocation to be higher than intended, or it will have experienced a downturn, causing your stock allocation to be lower than intended.

Rebalancing is the act of adjusting your holdings to bring them back in line with your ideal asset allocation. A periodic rebalancing program essentially automates the old adage, “buy low, sell high,” as you’ll be selling the portion of your portfolio that has increased in value so that you can buy more of the portion that has decreased in value.

It’s worth noting that rebalancing can be extremely difficult from a psychological standpoint. It can feel as if you’re selling your “good investments” to put money into your “bad investments.” The key is to remember that just because something has performed well (or poorly) recently doesn’t mean that it will continue to do so in the immediate future.

How often should an investor rebalance? That’s a tricky question. Some people advocate in favor of rebalancing once your portfolio is off balance by a certain amount (such as your stock allocation being either 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals, regardless of how off-balance your portfolio becomes in the interim.

Unfortunately, the best-performing rebalancing strategy varies from period to period, and it’s no easy task to predict which one will do best over the course of your investing career. Rather than spending a great deal of time and effort thinking about it, my suggestion is simply to pick one method and resolve to stick with it.

Simple Summary

  • Your tolerance for risk should be the primary determinant of your stock/bond allocation. Your risk tolerance is determined by how comfortable you are with investment volatility and how flexible your financial goals are.
  • Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.
  • For the sake of additional diversification, most investment professionals recommend investing somewhere from 20% to 40% of your stock holdings internationally.
  • Rebalancing is the act of adjusting your portfolio to bring it back in line with your ideal asset allocation. Rebalancing helps to automate “buying low” and “selling high.”

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Comments

  1. Mike

    You can distill a lot of wisdom in a small space.

    I can’t remember who said, that you probably are not diversified enough if there isn’t something in your portfolio that you hate at the moment.

    That advice can work two ways: first we can hate stuff that is going down in price, giving the appearance of a loss – if only an unrealized one, unless we have to sell. Second, we can be nervous about our investments going up too far or too fast, which makes them seem too expensive [if we are still saving] and maybe even “more dangerous” [i.e. in danger of mean reversion, or going back down].

    Regards,

    Jim

  2. Mike,

    Regarding rebalancing, you stated . .”your stock allocation being either 10% higher or 10% lower than intended .” . .
    I guess there’s two ways of interpreting your comment (relative or absolute). Just curious if you could give us readers a real world example!

  3. Jim,

    I like that quote — “you probably are not diversified enough if there isn’t something in your portfolio that you hate at the moment.”

    Only exception I can think of: people who own exclusively balanced funds or funds of funds that work similarly. :)

  4. Forrest,

    I had meant 10% of overall portfolio value (as opposed to 10% of the desired stock allocation). That said, I do not think there would be anything wrong with rebalancing in the other manner, other than the fact that it would be more work because it requires rebalancing more frequently.

    My primary point with regard to rebalancing was that the specific method doesn’t matter as much as having a method.

  5. I understand your primary point: Better to have a method.

    But, if one chooses the 10% of portfolio method, is the below example a correct interpretation?

    Beginning Equity /Bond split (60%/40%)
    ====================
    Assume that after a bull market, the ratio has changed to (66%/34%). Now, if one uses a “10% rule,” would this trigger a rebalance? (eg, 60% x 1.10 = 66%). Or do you mean that stocks would have to climb to 70% to trigger a rebalance (eg, 60% + 10% = 70%)?

    (I’m assuming no taxes – don’t want to muddy the waters!)

    Thanks Mike!

  6. To use your example, I had meant that stocks would have to climb to 70% (or fall to 50%) to trigger a rebalance.

    But I think the other method would be reasonable as well.

  7. Thanks!!!!! I got it now

  8. Very nice article Mike. :-) My compliments to you! :-)
    Happy trails, Mike

  9. Clif Bridegum says:

    Mike,
    This article provides a fantastic summary of things that new investors should consider when planning for retirement.

    Great Job!

  10. Mike, just to stir the pot a little: You write, “Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.” I agree, and will be rebalancing soon to meet that goal. But that being the case, why would you have invested in a VG target fund that you later acknowledge is more aggressively allocated than most investors would prefer?

  11. Larry,

    I don’t think I understand what you’re asking. When I point out that Vanguard’s target retirement funds are more aggressive than many investors would like, the whole point is to reduce the likelihood that somebody will accidentally end up with an allocation that’s too aggressive as a result of picking solely based on the date in the name.

  12. I think I see what I was missing. So where VG as a rule starts its glide paths towards being more conservative some 25 years before “retirement,” you could (as a person I believe 25-29 years of age) choose for example the 2035 fund where the glide path has already started, rather than the 2050 fund where you would have much longer before the fund started to become more conservative. (I’m sure you mention that in the book, but I didn’t connect all the dots.)

  13. Yes, exactly. When it comes to Vanguard’s target funds, I think many investors would be better served by picking a fund that is intended (by Vanguard) to be for investors who are significantly older.

  14. Regarding the rule of thumb test for stomaching volatility, I was contemplating what I’d do with a large lump of cash that may be coming my way.

    For the past four years it’d have gone straight into equities of some sort or another. But I think I can no longer face another 50% net worth loss in two years straight. Perhaps it’s partly I’m older, and partly as you say the sums at risk have grown larger.

    I still can’t face government bonds at barely 2% (heresy I know — and my pure passive co-blogger agrees — although actually I remember your post “Why not 100% stocks?” now I think of it).

    But I can get 4% on a cash savings account here in the UK (with some constraints on withdrawal) and I think it might have this money’s name on it!

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