The Wall Street Journal directed that question to retirees Monday. It’s really a good question not just for retirees, but investors of all ages. Research shows that asset allocation accounts for more than 90% of investment returns.
Let’s start with retirees. The old “wisdom” was that you subtracted your age from 100 and that was how much of your portfolio should be allocated to stocks. The balance was suggested to be in fixed income. So, this rule of thumb would conclude that most investors age 70 would have 30% allocated to stocks and 70% allocated to fixed income. That’s likely the wrong allocation today for three reasons:
- The equity allocation may be high or low.
- The fixed income allocation is likely too high these days.
- There are no alternatives in the allocation.
For retirees and investors of all ages, the answer lies not in the age of the investor but their risk profile. Our regular readers know that risk has three components:
- Risk Tolerance – Are you a risk taker? This is typically reviewed through use of a questionnaire.
- Risk Capacity – How much money can you afford to lose? This is typically reviewed by estimation of worst case outcomes in relation to your net worth.
- Risk Perception – This is a subjective judgment people make about a given risk at a point in time.
Every investor has their own unique characteristics as far as goals, income, expenses, net worth, legacy wishes, expected longevity and risk profile. We have clients in their 60s, 70s and 80s with a “growth” or “aggressive” risk profile. They may or may not be working, don’t withdraw a large percentage annually from their portfolio, are comfortable with risk overall, have enough net worth where they can afford to lose an expected given portion of their assets and they have a low perception of danger of a given risk. Hence, based upon their unique characteristics, their asset allocation might be 60% equity, 20% fixed income, and 20% liquid alternatives. A far cry from 30% equity and 70% fixed income based on their age alone.
Conversely, we have some young clients who don’t like risk and have a “defensive” or “conservative” risk profile. Their asset allocation could be 30% equity, 35% fixed income and 35% alternatives. Everyone is different.
Another rule of thumb that needs review is the 60/40 portfolio. The traditional “balanced risk” portfolio is 60% stocks and 40% bonds. Some financial advisers recommend this 60/40 portfolio to their clients of all ages and all risk profiles. To them, the mix is what Goldilocks would say is “just right.” They recommend you “set it at 60/40 and forget it.” Unfortunately, it hasn’t worked well since 2000. Many of their clients should have had less allocated to stocks and more to bonds through 2011. And, now with the bond bull market seemingly over, they face the prospect of reducing the bond allocation but don’t want more in equity.
These first five weeks in 2014 remind us that the stock market doesn’t always go straight up and diversification is key. It’s no surprise that we continue to see more and more industry literature suggesting investors and advisers consider liquid alternatives for a portion of their portfolio – something we’ve been doing for ourselves and our clients for over seven years. Instead of a 60/40 portfolio, the DWM allocation for an investor with a balanced risk profile these days might be 50% stocks, 25% bonds and 25% alternatives.
Lastly, risk profiles change over time. Many risk profiles are different today than they were in early 2008. We live in a different world today than six years ago and it’s always changing. That’s why we are continually monitoring and managing the investment environment and meeting with our clients to help them with their financial goals and review their risk profiles. That’s what we call Total Wealth Management or “TWM.”
Beware of advisers that rely on antiquated rules of thumb (such as using your age for your asset allocation) or suggesting a 60/40 set-it-and-forget-it portfolio. Identifying and maintaining the appropriate asset allocation requires a lot more work. It requires a robust financial planning and investment management process like DWM’s TWM. If you’d like more information please give us a call.