Unique Asset Allocation

Asset allocation is easy to explain, more difficult to actually construct.

That is because one size does not fit all investors.

Unfortunately, many investment models try to lump investors into boxes as to a target asset allocation.

The “One Size Fits All” Approach

You will often find asset allocation models that recommend determining your asset allocation based on age.

For example, start with 100 and subtract your age. That is the percentage of capital you should invest in equities. The remainder would be invested in fixed income and cash equivalents.

If you are 25, you invest 75% in equities. Over time you would adjust down your percentage in equities. At 45, your allocation will be reduced to 55%. By the time you reach retirement age, the majority of assets will be in lower risk investments that yield a fixed income stream.

The logic is that the younger you are, the longer the investment time frame you enjoy. The longer the time horizon, the greater the investment risk you can endure (increased volatility will average out over the longer number of years). Based on the risk-return relationship, the greater risk should mean the investment will have a higher expected return over time.

Simple. Makes some sense.

You can use this system as a guideline or starting point in your calculations. But unless you want a weak solution, do not use this approach alone. Or any other cookie-cutter system.

If you deal with a financial advisor who employs this method, I suggest you ask some hard questions before signing on.

It is not an approach I would recommend. Not to mention, you still need to allocate your initial 75% amongst a myriad of possible equity sub-asset classes and actual investments. That also requires some expertise and effort.

You will see variations on the age asset allocation model. Some incorporate basic risk questions. Others add in salary or a few other factors. But they tend to be relatively generic and contain 5-7 possible allocations. The recommendation being the allocation where you come closest.

Simple, easy, but not very attuned to your uniqueness.

Investors are Unique Individuals

As I have written before, it is your unique comprehensive investor profile that should drive your asset allocation. Not a generic formula with a limited number of factors.

Yes, age (i.e., time horizon) is a variable.

Who are You?

But you also must factor in your: current financial situation; phase of the life-cycle; investment objectives and constraints; liquidity requirements.

If you do not, success will be extremely difficult.

Imagine that at age 25 you win the lottery or inherit money from a wealthy aunt. $2 million.

Using the 100 less your age method, you would allocate 75% of the money to equities.

But should you put $1.5 million into equities? Maybe, maybe not. It depends on the other variables in your life.

Did you have $5 million before the $2 million was added or did you have no assets but a lot of debt? What are your other sources of income? Do you want to retire tomorrow or continue on the path to company president? Did you just have triplets and three times the expenses you originally anticipated when planning a baby? Do you intend to buy a $1 million home in 6 months? Is your sister challenging the inheritance in court, such that you may need to share the wealth and pay some legal fees? And so on.

These issues all relate to your personal financial situation, both current and desired.

What is Your Risk Tolerance?

With respect to your investment approach, what is your risk tolerance?

Do you take a rational approach to investing? Do you realize that there may be large swings in your portfolio’s market value and that your $2 million may fall in value?

Or are you like many investors, more emotional in nature?

Are you someone that reaches for the antacids every time the S&P 500 dips half a percent? If so, you might prefer to sacrifice some potential returns in exchange for liquidity, stability, and safety of the capital. What good is $2 million if it erodes to $500,000 due to volatility in the markets or bad investment choices?

Or, are you on the other extreme? Equities? No way! That money is going straight into an options and futures trading accounts. It was found money and you will leverage it to the hilt. Then buy your own island in the Caribbean and proclaim yourself ruler! If you lose it all, well it makes for a fun story at the pub with friends (or in the welfare line).

Do you like the safety of government backed securities? Or do you want to trade options? Or are you somewhere in the middle?

How you perceive risk will greatly impact your asset allocation.

Determining Your Personal Asset Allocation

Understand Your Financial Situation

Knowing where you are today, and where you want to go, is important in determining asset allocations.

Your current financial situation is simply a snapshot of your life at one moment in time. As you get older and move through the life-cycle, your wealth, objectives, constraints, and risk tolerance, will undoubtably shift. Always be prepared to revise your investor profile as needed.

Subsequently, as your investor profile shifts, so too should your target asset allocation.

Also, be realistic in your objectives and constraints.

If the stock market has averaged returns of 8% per annum over the last 10 years, it might be unrealistic to assume you will earn 25% annually on your portfolio. Or if you just graduated from university, it might not be best to plan on being President of a Fortune 500 company by the time you are 30.

Both could happen, but I suggest that you take a conservative approach to your plans. Underestimate your objectives and overestimate your constraints. That may save a lot of disappointment later.

Develop a comprehensive plan of action and work toward your goals. It is surprising what is attainable if you put your mind to something. But for financial planning purposes, factor in a margin of error in your assumptions and targets. It is better to worry about dealing with excess wealth than to in arrears when you wish to retire.