If I had to know just one thing about an investment portfolio, it would be its overall asset allocation. The portion of your investments in equities (such as stock mutual funds) and fixed-income (such as bond or stable value funds) tells us more about its performance than anything else. Over long periods it’s mattered much more than exactly what individual investments you choose within those broad categories.
If asset allocation is your portfolio’s most important attribute, then we should take care to arrive at a good target for your situation. This is one area of financial planning in which there are many rules of thumb. Perhaps the best known is to take your age (or average ages if you’re married) and make that the fixed income percentage. Say you are 55 and your spouse is 59, you’d take the average of 57 as the fixed income target while your equity percentage would be 43 percent.
This isn’t a terrible answer, but it doesn’t take in account many important factors. Do you plan on retiring at age 60 or 70? Would you rather have a financial independence goal when you could shift to half-time work or a profession that pays less? The total value of your combined investments is also critical. If you’ve have already won the retirement game by aggressive saving, then you may not need to take much risk at all to accomplish your goals.
With all of this being said, the best allocation for you must be one that you will follow in times of optimism and fear. It’s our natural inclination to want to sell investments after they have declined, and purchase them once they have appreciated. In short, our minds tell us to buy high and sell low. You need an investment strategy that you can lean on to fight this destructive atavism. If you’re committed to 70 percent equities and 30 percent fixed income, this is a decision that must endure through bear and bull markets.
One useful exercise is to review how a recommended asset allocation would have done in a time of calamity. We have the period between November 2007 to February 2009 in our recent history as a good stress test. A diversified 80 percent equity and 20 percent fixed income portfolio by one estimate would have lost 36 percent of its value. While a 50 percent equity portfolio would have lost 17 percent.
Take these numbers and put them in real terms with your portfolio. If you have accumulated $600,000, imagine your reaction to a $216,000 loss with an 80 percent portfolio. Of course it would be devastating. There are three choices you can make when this happens. You can do nothing, rebalance and shift back into equities, or liquidate your portfolio by moving to cash.
You want to settle upon a target investment allocation that under dire circumstances you would not abandon. All of the formulaic approaches may be pointing toward 70 percent in equities, but it’s not the right answer if that level of risk in a very poor market would cause you to sell. That one poor decision could delay retirement by years.
For this reason, it’s vital that you have confidence in your investment advisor, whether you’re managing your own investments, working with a big mutual fund company, or a local financial planner. Vanguard in its Advisor Alpha study estimated that behavioral coaching and rebalancing add 1.85 percent to the annual returns of an “average” investor. If you’re self-directed, make sure you would follow through on a strategy even once you’re retired. Use the bear market decline figures to replicate how you would react. If you’re working with an advisor (corporate or personal), ensure you have the relationship that would enable them to counsel you effectively in all market conditions.