Do You Have the Right Asset Allocation?

In the midst of the meltdown yesterday, I got an email from my wife. Several of her work colleagues had been discussing the carnage in the markets and she was worried: our daughter will start university next year, and my wife wanted to make sure our RESPs would survive another crash.

The answer was yes, of course. Knowing that we’ll need about $15,000 this time next year, I’ve set aside that amount in cash. Another 60% of our daughter’s RESP is in bonds, with the duration carefully matched to our time horizon. The account has less than 15% in equities, which I will move to fixed income over the next couple of years. With that asset mix, even a 50% decline in the equity markets won’t jeopardize our investment plan one bit.

My RRSP, on the other hand, is 70% equities, so it has taken quite a hit over the past few months. I’m not thrilled about that, but since I don’t need the money for at least two decades, this latest market mess is nothing but a speed bump. In fact, I’m trying to scrape together some cash to take advantage of the fire sale.

I’m sharing this little anecdote because it’s a reminder that choosing an appropriate asset allocation is the most important investment decision you’ll ever make. Your portfolio’s overall mix of stocks and bonds not only has to match your comfort level with risk, but also the time horizon of your investment goal.

It’s natural to get spooked during a market crash. But if you’re panicking, if you’re genuinely concerned that your portfolio won’t recover before you need the money, or if you’re tempted to get out before things fall further, then you’ve got an inappropriate asset allocation. You need to reconsider your ability, need, and willingness to take risk.

No surprises

Market turmoil is inevitable: it’s happened before, and it will happen again, so there is no excuse for being blindsided. Anyone who invests in equities—and that includes broad-based index funds—should be prepared to lose half their money. Of course, you can expect to recover eventually, but after a 50% loss, your investment needs to double before you get back to even—and that can take several years of double-digit returns. If you don’t have that much time, then you need to keep most of your portfolio in safer investments, such as short-term bonds and cash. Yes, interest rates are low, but that is the price of safety.

In The Warren Buffet Way, Robert Hagstrom describes the great investor’s advice on this matter: “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.”

The road to financial ruin is paved with the bodies of investors who overestimated their ability to take risk. A properly designed investment plan—and a spouse who keeps tabs on you—will make sure you’re not one of them.