Many private investors struggle to get their heads around the concept of asset allocation [2], but it is the cornerstone of sensible investment.
One idea, courtesy [3] of The Oblivious Investor, is to think of asset allocation in a similar way to the food pyramid [4] that many of us learned at school.
The key here is that as a long-term investor you want to own more of the assets at the bottom of the pyramid and fewer of those at the top.
Specific percentages will depend on your age [5] and risk tolerance [6].
For example:
- A young investor should have substantial long-term exposure to equities.
- A retired investor living off their income [7] would typically have shifted a big chunk of their equity funds into cash, bonds, and even (whisper it!) annuities [8].
All very sensible, although if I could afford a Monet I’d be tempted to head to the top of the pyramid early.
Waterlillies are so much prettier to look at than the dealing screens of online brokers [9].
Be roughly right
Rules of thumb [10] such as this pyramid are useful to get past the decision paralysis that can plague new investors.
It also helps to remember that the perfect asset allocation doesn’t exist. Asset allocation is as much art as science.
Even Nobel Prize-winning Harry Markowitz didn’t bother working out his own theoretically perfect portfolio, saying [11]:
“I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.”
But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it.
So I split my contributions 50/50 between stocks and bonds.”
Markowitz’ focus on his tolerance for loss is also something for new investors to learn from.
If your equity allocation is above what your risk tolerance can handle in a stock market crash then you’re potentially heading for the rocks.
Selling out at the bottom of a bear market [12] because you want to stop the pain could leave you stuck shopping at the Tesco Value baked beans end of the food pyramid in your old age.
Fine to go there when saving money [13] for your financial freedom – but ideally you want to be able to get reckless in Waitrose once in a while when you retire!