If I were to ask you to name the factors that could impact—or even upend—your investment plan, what would you say? Would you point to current events (natural disasters, wars, elections)? Inflation? Government legislation? Interest rates? If so, you wouldn’t be wrong. None of these answers are off-base—and all of them will play some kind of role—but I wonder where on your list you would land. Because here’s the reality: your own psychology—specifically, your emotional reaction to volatility—could well be the greatest factor you contend with on your journey. Your ability to remain disciplined, trust in your plan, and to “keep your head when all about you / Are losing theirs” (to quote Kipling) will directly impact your level of success with investing. Yet unfortunately for many investors, this is underestimated or even overlooked entirely.
Here’s the reality: your own psychology—specifically, your emotional reaction to volatility—could well be the greatest factor you contend with on your journey.
We aren’t going to make that mistake. Here’s a crucial point to know at the outset: the market can be extremely volatile at times, and try even the most stoic of investors. We need look back no farther than March 2020, when the S&P 500 dropped 32% in just over a month, the quickest drop of this magnitude in history (even outpacing declines seen during the Great Depression). Or, consider that the two most significant bear markets (a market decline of 20% or more) in the last couple of decades lasted for years: the Dot Com Bubble (2000-2002) took 7 years for the market to recover its previous valuation; the Great Recession (2007-2009) took over 5 years. Being in the market is not for the faint of heart, and considering all of this, having a portfolio that is suitable for you is imperative. When a portfolio’s risk level exceeds an investor’s tolerance for risk, this leads to the kind of emotion-driven decisions that rarely have a good outcome. The highly technical mathematical equation for this concept looks something like this:
Here’s the thing: your investment plan must balance your desire for the highest return with your own tolerance for risk. Your asset allocation is the chief determinant establishing where levels of risk and return intersect for your portfolio. The best way to provide a suitable framework for your portfolio, ensure that you are properly diversified, and insulate your plan from your emotions, is through establishing an appropriate asset allocation and sticking with it. It is the cornerstone of your investment plan, and will act as your guide in the years to come in tracking whether you are keeping to that plan, or straying off course. It is the most important decision you will make in building your portfolio.
In his book All About Asset Allocation, Rick Ferri references two studies that, together, really drive this point home. Researchers “Gary Brinson, L. Randolph Hood, and Gilbert Beebower…analyzed the returns of 91 large U.S. pension plans between 1974 and 1983…they concluded that asset allocation explained a significant portion of portfolio performance. [They] published a follow-up study in 1991 and essentially confirmed the results of their first paper: more than 90 percent of a portfolio’s long-term return characteristics and risk level are determined by asset allocation” (20). (Many thanks to my friend Don Gaines for passing this along!)
Let that sink in. More than 90 percent of your portfolio’s long-term risk and performance characteristics will be determined by this one decision. Now that I have your attention, let’s get started.
What is Asset Allocation?
So what exactly is asset allocation? Put simply, your asset allocation is your portfolio’s “mix” of the asset classes you’re invested in. As we discussed back in Part 7, there are three types of index funds we will be basing a portfolio around; these correspond to the three asset classes that I believe most investors should consider. To recap, they are:
- U.S. Stock Market Index Fund
- International Stock Market Index Fund
- Bond Market Index Fund
The percentage of your total portfolio devoted to each of these asset classes is called your asset allocation. Notice I said “total portfolio” there; if you have multiple investment accounts with the same goal (such as retirement), your asset allocation should include all of them together—your entire portfolio. This mix will be tailored to you individually as an investor. So, as an example, an investor’s asset allocation might look like this:
As I mentioned above, this mix will vary from investor to investor—sometimes widely. I talk to investors frequently who hold a very simple portfolio of 100% U.S. stocks (no international stocks or bonds); investors in retirement might hold a portfolio of 20% U.S. stocks, 10% international stocks, and 70% bonds; Kristy Shen and Bryce Leung (authors of Quit Like a Millionaire) chose an allocation of 20% U.S. stocks, 40% international stocks, and 40% bonds at age 25; and my own portfolio includes 64% U.S. stocks, 16% international stocks, and 20% bonds. Here’s what matters: as long as investors have carefully considered their personal allocation—weighing out the risk and return characteristics it brings to their portfolio, and ensuring that it is appropriate for their time horizon and personal risk tolerance—their allocation is suitable for them.
As long as investors have carefully considered their personal allocation—weighing out the risk and return characteristics it brings to their portfolio, and ensuring that it is appropriate for their time horizon and personal risk tolerance—their allocation is suitable for them.
There are a couple of concepts we’ve touched on here that are central to asset allocation, and need more explanation. Let’s do that now. Generally speaking, your asset allocation is based on two factors:
- Your time horizon
- Your personal tolerance for risk
Each of these is critical, and needs to be evaluated to find an asset allocation that’s suitable for you. Let’s spend a little time getting more in-depth with each, and then we will discuss exactly how to go about determining your asset allocation.
Put simply, your time horizon is the amount of time you expect to hold an investment before needing to access the money. So, as an example, if you are 25 years old, and are investing for retirement (which you estimate will be at age 60), your time horizon is 35 years. Here’s why this is important: the length of your time horizon directly impacts the amount of risk you can afford to take with your investments. Generally, when people are younger (decades out from retirement), they can afford to be a bit riskier with their investments, as they have the time for the market to right itself after any dips they might run into. As people get closer to retirement age, however, it’s better to increase the amount of money they hold in assets that are stable, protecting wealth and minimizing risk. This generally means that investors will be more heavily weighted in stocks in their early investing years, and less so in their later investing years.
The length of your time horizon directly impacts the amount of risk you can afford to take with your investments.
This also means that asset allocations are not static; they change over time. As an example, an investor might start out with an asset allocation of 90% stocks and 10% bonds at age 25, but gradually adjust it over the decades to end up with 50% stocks and 50% bonds at retirement age; this change in allocation over an investment window is known as an investor’s glide path.
Another consideration: if you have several savings goals, each with a significantly different time horizon, you should consider a separate asset allocation for each. For example, if you are saving for retirement (estimated time horizon = 35 years), as well as a down payment for a home (estimated time horizon = 7 years), you should not have the same asset allocation for both. Here’s why. If you are 35 years away from retirement, you can generally afford to take on more risk, as you have the time for the market to right itself after periods of volatility. However, if you have a time horizon of only 7 years (for your down payment), you can’t afford to take on the same level of risk; the market may not have enough time to correct itself before you need the money. Remember what we discussed above: some bear markets last for years, and reach losses of 30-50%; consider facing that situation a year out from buying a home, and either having to settle for a smaller down payment, or possibly wait years for the market to correct itself before buying your home. This is also the reason that I believe short-term savings goals (5 years or less) should be mostly (if not entirely) in safer assets—the chances of adverse conditions affecting your success are just too great.
Personal Risk Tolerance
I want to be clear: where investing is concerned, emotion is your enemy. Intuition will fail you, time and time again. Neither are reliable foundations for your investment plan, and you should strive to insulate your investment decisions from them as much as you can. Over the years, I’ve come to realize one thing above all else: being truly successful at investing is as much (if not more) about mastering your own emotions as it is developing a proficiency. John Bogle said it best: “Speculation leads you the wrong way. It allows you to put your emotions first, whereas investment gets emotions out of the picture.” If the level of risk you take on in your portfolio exceeds your tolerance for risk, this may cause you to make decisions that can be devastating to your portfolio. Your risk tolerance always needs to be kept in view when making investment decisions.
“Speculation leads you the wrong way. It allows you to put your emotions first, whereas investment gets emotions out of the picture.”John Bogle
So, how exactly does your asset allocation define the risk profile of your portfolio? Well, you might remember from our discussion in Part 4 that stocks are riskier (more volatile), but can provide a better rate of return. Bonds are more stable (less volatile), but offer a lower rate of return. Thus, it follows that by adjusting the proportions of stocks and bonds in the portfolio, we adjust a portfolio’s risk profile. By increasing the proportion of riskier assets (stocks) and lowering the proportion of more stable assets (bonds), we will make a portfolio riskier, and vice versa. So, a portfolio with 90% stocks and 10% bonds will be riskier (but should also offer a higher return) than one with 60% stocks and 40% bonds. To illustrate this, consider this graph from Vanguard, showing various allocations (listed in the center), along with the highest annual gain (top bar) and worst annual loss (bottom bar) for each:
So, as we move through the various allocations from left to right, we are also going from aggressive (100% stocks and 0% bonds) to conservative (0% stocks and 100% bonds). Consider what happens to the portfolio’s volatility as we go. With a portfolio of 100% stocks (far left), we also see that this portfolio had a best year with a gain of +54.2% and a worst year with a loss of -43.1%; said another way, this mix can be very volatile. At the other end, 100% bonds, we see a best year of +32.6% and a worst year of -8.1%—a much more stable mix. It’s important to note that these metrics show the best year and worst year, not the typical year, but it should give you some idea of the kind of volatility that’s possible with each allocation.
The missing factor here, of course, is return. If we added this information in, you would see that the 100% stocks portfolio, while having much greater volatility, also offers the potential for greatest return; it has historically (1926-2020) provided an average annual return of 10.3%. At the other end, our 100% bonds portfolio offers less volatility, but does so at the expense of potential return; this portfolio has historically provided an average annual return of 6.1%. The portfolios between them, of course, follow the same trajectory: as volatility decreases, so too does potential return.
As you might guess, quantifying something as subjective as your risk tolerance can be difficult, as the primary factor we are working with is how you “feel” about something. For some investors, this takes a bit of trial and error—starting out with one allocation, and finding (as they experience volatility) that it needs to be adjusted to be suitable for them. There’s nothing wrong with this. In considering your portfolio in view of your personal risk tolerance, you are setting yourself up for success. Always remember: a good asset allocation will balance the desire for the highest return with your tolerance for risk.
All that said, how exactly should you find the best starting allocation for you? Let’s walk through the process step-by-step.
How to Determine Your Asset Allocation
Determining the best asset allocation for you as an investor involves two important decisions:
- Decide on your overall allocation of stocks to bonds.
- Subdivide your stocks allocation into U.S. and international stocks.
We’re going to cover the first of these (your overall allocation of stocks to bonds) in this section. The second consideration (international stocks) will be the focus of Part 10, as it tends to be an area of some debate, and it’s worth spending some time on. So, stocks and bonds. To get a rough starting point, let’s use a quick method—a rule of thumb called the Rule of 110. It goes that:
110 – Your Age = Your Stocks Allocation Percentage (U.S. + International)
So, as an example, a 35-year-old using this method would have an asset allocation of around 75% stocks (and 25% bonds). The beauty of this method is that it also provides a rough guide for how your asset allocation changes as you age. Using our previous example, when our investor reaches 65 years old, their asset allocation would have changed to around 45% stocks (and 55% bonds). Write this allocation down for now.
The next method we are going to use is Vanguard’s Investor Questionnaire. This questionnaire is an excellent tool, and will take both your time horizon and risk tolerance into account before recommending a starting allocation for you. Set aside about 10-15 minutes for this. Some of the questions will ask you about specific situations you might face as an investor, and you may not be sure how you would handle them; just do the best you can! You can access the questionnaire here:
Once you’ve completed it, write down the recommended allocation next to your answer from the Rule of 110 (above). How close are the allocations? If they are varied, don’t worry. We’re now going to “try some allocations on,” so to speak, and see which fits you best. To do this, we will be using Vanguard’s Model Portfolio Allocation data. This is similar to the graph we saw above when we were discussing risk tolerance. You can find it here:
For various model allocations (ranging from 100% stocks to 100% bonds), you will find the following info:
- Average annual return
- Best year
- Worst year
- Number of years with a loss
Here’s what I want you to do. Locate your recommended allocation(s) that you’ve written down. If yours isn’t on the list, find the closest two allocations to it. Evaluate the average historical return, as well as the data for best year, worst year, and number of years with a loss. Try to really visualize how that allocation would suit you. For example, if your recommended allocation from above was 80% stocks and 20% bonds, how would you handle a portfolio that has had a worst year with a loss of -34.9%, and ends about 1 in 4 years (24 out of 95) with a loss? Would you be able to handle watching your portfolio drop 34.9% in a year without reacting emotionally?
You might notice that visualizing an allocation provokes a certain response. For example, if the numbers above feel like too much volatility for you, this might mean that you need to look at a more conservative portfolio (such as a mix of 70/30 stocks to bonds). Or you might feel that you can handle more volatility in pursuit of a higher return; in this case, you might look at a more aggressive portfolio, such as a 90/10 or even 100/0 mix of stocks to bonds. Remember: your allocation should suit you. In the long run, whether you are comfortable with your asset allocation will mean far more than having followed a rule, or the results of a quiz. If you are comfortable with your portfolio risk, you can ride out any storm.
One caveat: I know we’ve spent quite a bit of time discussing the importance of your asset allocation, but please don’t stress yourself out and put too much weight on this decision. As I said above, this is your starting allocation: you can—and likely will—change your allocation after you’ve taken it for a test drive, and experienced volatility in the market. Once you’ve found an allocation that feels right for you (and suits your goals), write it down. If you’re using the FFWF Investing Guide Checklist, you’ll find a space for it there. Leave me a comment below, and let me know what your asset allocation is! How did you come up with it?
Congratulations! You’ve taken a huge step forward in creating your own portfolio, and should be proud! Up next in Part 10, as I mentioned before, we will be discussing how to allocate your stocks portion between U.S. and international stocks. See you there!
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