How do you determine your asset allocation?

Asset allocation is perhaps one of the most important concepts investors and financially savvy people can know. You should be asking yourself, two questions. One, how old you are? Two, what your risk tolerance is? And you should be asking yourself these questions when you first create a portfolio for investment and then every year after.

The three main types of assets

1. Equities (stocks):

Equities represent shares in a company. They are ownership in a company, buy enough of the companies shares and you’ll eventually get on the board of directors (although that’s unlikely for most investors). Equities are the most volatile of the three assets that we’ll be covering here. Historically equities have out preformed other asset classes. This is why they are typically good investments for money you won’t be needing anytime soon.

However, even within the asset class of stocks there are a wide range of them. Here’s a quick guide:

• Value stocks — Companies perceived to trade at a discount to their peers. They’re generally considered well-established businesses with strong fundamentals.
• Growth stocks — Companies that are growing faster than average and therefore offer the potential for greater returns than value stocks, as well as greater risk of losses.
• Large-cap stocks — Generally speaking, companies whose market capitalization is $5 billion or greater, though some definitions set the threshold higher or lower.
• Mid-cap stocks — Companies with market caps of $1 billion to $5 billion.
• Small-cap stocks — Companies with market caps of less than $1 billion.
• International stocks — Funds that invest in companies based outside the U.S.
• Global stocks — Funds that invest in companies all over the world, including the U.S.
• Emerging-market stocks — Funds that invest in stocks based in rapidly growing, young economies. Countries like China, Brazil, and India are examples of emerging markets, as opposed to developed economies like the U.S., the U.K., and France.

Below we can see the maximum and minimum returns or draw downs you might expect while holding Stocks, Bonds, and T-bills. If you don’t need the money for the next five years, you’re probably in a good position to put the money into stocks and bonds while still making a return. But if you need it sooner, you may ask yourself, can I cover or accept a loss of 30% or more in my principal. This is when you should be asking about your risk tolerance.

Credit: ralphwakerly.com

2. Fixed income (bonds):

Fixed income assets make regular interest payments based on a agreed interest rate. These payments often remain the same over time (fixed income bonds) or sometimes they can change over time based on market rates (variable interest rate bonds). One example of a variable interest rate bond is inflation protected bonds which make higher payments during periods of inflation. Generally speaking, and contrary to Dave Ramsey’s opinion, bonds are less risky than stocks. But shown above, they are not risk free.

3. Cash:

This category refers to physical cash, as well as interest bearing accounts like an interest-bearing checking at SoFi or a savings account. Cash and a bank account or savings account are risk free, if it’s FDIC insured. However, even if the bank account bears interest it’s unlikely that it will keep up with inflation this makes cash investments bad long-term investment vehicles.  

General rules for asset allocation

Now with defining some of the asset classes out of the way we can get to rules of thumb. The most commonly used metric and one you’ll find in many target date funds, is a age based rule. There are around three suggestions with this metric or three guidelines. For conservative individuals using a “100 – age” calculation is a good starting point. For moderate risk takers using a “110 – age” based rule is a decent suggestion. While, for more aggressive individuals using a “120 – age” based rule is another option.

So for an aggressive risk taker using this way to calculate asset allocation, if I assume they are 25 years old, the calculation would be: 120 – 25 = 95. This means that 95% of their invest-able assets should be in stocks and the other 5% should be in bonds. And for people nearing retirement the amount in stocks becomes lower and the amount in bonds increases.

While these are helpful guides, I don’t think these accurately take into account our personal risk tolerance. For example, if a 50% loss doesn’t scare you at all – as in you’ll sleep like a baby – then being 100% in stock or even being over 100% stock and adding leverage might be a good asset allocation for you – and checking out our newsletter might be a good idea. But if you can’t stand even a 5% loss then dialing the risk way down and having the majority of your assets in T-bills or cash might be the best option for you.

I’d suggest three things for determining asset allocation. I’d use the aggressive age rule, then I’d take the vanguard risk tolerance quiz, and then I’d look below at the “Sleeping Scale of Major Investments” from A Random Walk Down Wall Street.

All of these should factor into your personal asset allocation. You can either choose to keep it simple and choose one of the age-based calculations, or ideally in my mind, use the age-based calculation as a base and let the Vanguard quiz guide you and the “Sleep quality” guide you as well. Ultimately, asset allocation is a very personal decision that you should make before investing and periodically throughout your investment career – And if you have a spouse, I might consult them too.

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