Ready, Willing and Able to Take Risk

Asset allocation is more art than science. There are no immutable laws to tell you what proportion of stocks and bonds should be in your portfolio. The best you can do is adopt rules of thumb. “Make your bond allocation equal to your age” is a popular one, as is “Don’t invest in equities if you will need the money within five years.” In the end, it comes down to a trade-off between risk and expected returns.

I found a lot of useful insights on asset allocation in Larry Swedroe’s newest book, The Only Guide You’ll Ever Need for the Right Financial Plan (Bloomberg/Wiley, 2010). Swedroe, who writes the Wise Investing blog at CBS MoneyWatch, is one of my favourite financial authors because he always backs up his arguments with hard data and practical advice.

His new book is written for an American audience and most of the financial planning advice isn’t useful for Canadians. However, a large part of the book is devoted to asset allocation decisions, which should be based on “the ability, willingness and need to take risk.” Let’s break down these three factors.

The ability to take risk

Swedroe says your ability to take risk depends on your investment horizon and the stability of your income (or human capital). If you’re 25 years from tapping your savings, or if you’re a senior public servant, you can keep a large portion of your portfolio in stocks. If you’re three years from retirement, or if you’re a commissioned salesperson, you should hold a far greater proportion of fixed income investments.

Swedroe offers these guidelines when considering the right equity allocation for your investment horizon. You can increase or decrease these suggestions based on your income security:

The willingness to take risk

How likely are you to panic when your portfolio loses value, as it inevitably will? Is a 25% drop going to give you ulcers? The willingness to take risk depends on your psychological makeup. Advisors give their clients risk-tolerance surveys to measure this willingness, but these are only worth so much. Only real-life experience — and we just had a litmus test in 2008–09 — will determine how big a loss you can truly tolerate.

Here’s Swedroe’s guidelines for determining a portfolio’s equity allocation based on the degree of loss you can accept without hurling yourself out the window:

The need to take risk

Finally, all investors should consider their need to take risk. If your financial plan suggests you’ll need a 7% annualized return for 20 years to retire comfortably, you’ll need a significant allocation to stocks. But if you’ve saved enough money to meet all of your financial goals, you might forgo all market risk. Swedroe tells the story of a couple in their 70s who had saved $13 million, only to lose $10 million by investing it all in tech stocks. The couple admitted that if their portfolio had doubled, it would have had no effect on their lifestyle or happiness. Why, then, did they put all that money at risk for no reason?

Swedroe doesn’t match specific asset allocations to target rates of return, which is smart, since no one can predict what the markets will give us in the future. However, in a previous post, I included a table of returns for different stock-bond mixes since 1970. Vanguard also publishes historical returns for several portfolio mixes going all the way back to 1926.

You may be surprised to see that a simple 50–50 portfolio has delivered long-term returns between 8% and 10% annually (depending which indexes you use and how often you rebalance). How many people need returns higher than that to achieve their goals? If you take more risk than that, make sure you have the ability and the willingness to stick to your plan.