Your asset allocation and investment strategy may work well in “normal” times. But how does it perform during a so-called Black Swan event? And what happens if you panic and reduce portfolio risk as the result of crashes?
An article by Jim Otar, “How asset allocation impacts portfolio recovery”, looks at this issue.
A few thoughts on the article from my side.
Markets are Overwhelmingly “Normal”
The media attention is always on the outliers and Black Swan events. Usually to the downside. So it appears huge corrections are fairly common.
Interesting to note that only 6% of the time, markets operated in a fractal mode. The other 94%, markets act in an expected, albeit often random, manner.
As the article points out, proper target asset allocation works well in normal times. You only have issues about 6% of the time. A good reason to “stay the course” and continue with a structured investing approach and plan.
Know Thy Risk Tolerance
True. I think this kind of gets glossed over in the article.
Investors should take a systematic approach to their risk tolerance. At times, this is difficult as emotions and behavioural aspects often intrude.
This is an area where a competent financial advisor can add value. Someone who is dispassionate. Who understands investing and how risk should be assessed within your portfolio.
Risk should not be about gut feelings. Though, they will play a part. If you are someone who is concerned about any minor loss, you will stay awake at nights if invested heavily in equities. So there is that to consider.
But if you learn about the risk-return relationship, portfolio diversification, how asset correlations can reduce overall risk, how time impacts riskiness, etc., that will (hopefully) alleviate some of the less rational concerns.
Asset Allocation and Life Cycle Phase
Part of one’s risk tolerance should be tied to time horizon and phase of life cycle.
If you are earning income and your main priority is retirement in 30 to 40 years, you have a relatively long time horizon. Ceteris paribus, you can invest in higher risk (with higher expected return) assets than someone who plans to retire in 3 to 4 years. Emotion is not involved. Just basic mathematics.
That said, most people have multiple investment objectives. Of varying time horizons. I am 30 and wish to retire at 65. I have a 35 year horizon. Perhaps my target asset allocation should be 80-90% equities.
But perhaps I wish to start a family and buy a home in 3 years. That changes the equation as I want greater certainty to ensure I have a down payment on the home. As well, maybe I want to start an education plan for my newborn. Or I need to consider personal insurance in case of health issues.
Your risk tolerance needs to reflect your investment objectives, their relative priority, and time frame.
Single, 30 year old me can sit tight and ride out any Black Swan events. Because I have a 35 year horizon and I will recover any short term unrealized losses. If I stay the course, I will do better than jumping in and out as the article’s examples show.
However, it is different for family starting 30 year old me. If I need $50,000 as a down payment on a home in 3 years, a Black Swan correction of 25% may not recover in 36 months. In the examples given, my behaviour and investing should be more like a 60 year old. At least for the portion of assets needed for near term objectives.
This is an area I often see problems. Individuals focus exclusively on retirement in 30 years and invest accordingly. But do not account for short term goals that require a different investment approach.
60/40 or 40/60 Asset Allocation Split
The article uses 60/40 or 40/60 equity to fixed income ratios in its examples.
Not too many years ago, a 60/40 split was often recommended for younger investors, with a move to 40/60 as retirement neared. Then, heavy into fixed income after retirement.
I think the author is simply using these splits in his examples. Not recommending them. Do not believe you should use either.
Your target asset allocation should reflect your unique investor profile. Not some cookie cutter approach.
For example, another “great” allocation calculation was to invest (100 minus your age) in equities. The rest in fixed income. If you were 30, that meant 70/30 split. At 40, 60/40. And so on.
Simple, yes. Useful, probably not.
See my comments above on the single 30 year old versus the 30 year old who wants to buy a home and start a family. Should they both have 70% in equities and/or identical portfolios? No.
Your target asset allocation should reflect your unique investor profile. Your financial position and realistic expectations. Where you are in your life cycle. Investment objectives by priority and time horizon. Constraints that may impact achieving your goals. And your personal risk tolerance.
All of these factors will determine the appropriate target asset allocation and drive your investing strategy. What might be optimal for you, may not be for a friend of the same age. As he/she will have a different investor profile. Perhaps similar, perhaps not. But not identical.
As your own personal circumstances change over time, then you will also differ from “past you”. Your investor profile should be updated to reflect those changes. And, as necessary, your target asset allocation and investment plan.
