You can’t make any worthwhile decisions about asset allocation without knowing why you are investing in the first place.
What do you want to achieve? What, in a nutshell, are your investment goals?
Asset allocation is the art (not the science) of putting together a portfolio of investable assets that gives you the best shot of meeting your goals.
The blend of assets you require will be determined by the magnitude of your investment goals and the answers to two further key questions:
- How much risk do you need to take? If you sit tight in low risk, low growth assets, the big danger is that you never reach your goal. Equally, if you’ve already amassed enough wealth to meet your needs, then why keep dicing with Mr Market? As passive investing guru William Bernstein puts it: “If you’ve already won the game, there’s no need to continue playing.”
- How much risk you can handle? If your goals require you to take big chances with risky assets but you have the financial stomach of a cowardly lion, you’re liable to bite off more stress than you can chew.
Pinning down your personal risk tolerance is extremely difficult – you won’t really know how much you can handle until you’ve experienced a damn good shoeing in the market. That’s why many people use rules of thumb to guide their asset allocation.
However, you can estimate the risk dosage you need to take by chunking down your investment goal into its component parts.
Owning the goal
Common investment goals are retiring early (or just retiring at all), paying off the mortgage, sending the kids to university, building a rocket ship to reach Alpha Centauri, and so on.
It’s also normal to start investing on the vague notion that you’d rather like to be rich(er).
Normal but dangerous.
The problem with a fuzzy goal is that it’s all too easy to abandon. There is no yardstick of success to keep you on track, and the plan can quickly be forgotten when disillusionment pays a visit.
Defining your plan with a few numbers helps to set it in concrete. It enables you to rationally assess the significance of the setbacks you meet along the way. And it creates a strong anchor point to cling to when the going gets tough, as it inevitably will.
Breaking down your investment goal
The key components of any investing goal are:
- Vision – For example, “I want to retire at 55.”
- Target – What is the number in pounds and pence that you need to achieve?
- Time horizon – How many years can you take to hit the target?
- Contribution level – How much can you invest? This may be a lump sum or a regular amount, such as £250 a month.
- Expected rate of return – What growth rate do you need for your contribution to mushroom into your magic number, given your time frame? You’ll need to come up with a credible expected return for your portfolio – and come to terms with the fact that expected returns are not guaranteed.
The good news is the vision is no more than a sentence. The numbers, too, are much easier to estimate than they first appear.
It’s also important to appreciate that – like planets exerting gravitational pull – the components of your investment goal directly influence each other.
When reality intrudes
You can use these relationships to try to solve any problems with your plan.
Can’t hit your target number within the time you’ve got left to invest? Then accept that you must reduce that target, or increase your contribution rate.
Can’t reduce your target figure or increase your contribution rate? Then maybe increasing your time horizon will square the circle.
Another solution is to increase your expected return, but you must beware of straying into the realm of fairy tales. If you want to be the master of your own destiny then you should only tweak the components you can control.
Doing your homework
The relationships between the moving parts of your investment goal become blindingly obvious when you use a financial calculator to help you work out the numbers.
Playing with the components of your investment goals is a valuable exercise as it enables you to:
- See how realistic your goals are and how much you’ll need to save to achieve them.
- Estimate how much growth you need over how long a period. (The less growth you need, the less risk you need to take. The less risk you can handle, the longer you’ll need to invest – or the more you’ll need to invest to hit a given target).
- Use that data and knowledge of asset class characteristics to tailor an asset allocation that takes into account your own need and ability to handle risk.
The process of defining an investment goal and adjusting it to suit your financial reality best slots into place when you work through a practical example.
To that end, we’ve previously shown you how to do that for retirement – the most difficult investing challenge most people will face. Go have a look!
Take it steady,
The Accumulator
Comments on this entry are closed.
This is a useful tool for playing with savings rates, returns and timescales:
http://networthify.com/earlyretirement#
I have no connection with networthify. Personally I am heavily into stocks, with only a small proportion in government and corporate bonds, mostly in trackers and the rest in a High Yield portfolio. My aim is to keep building my pot and then gradually move it out of accumulation and into income class shares and my HYP in about ten years time, when (if) I hit 50.
Hi TA
InvestorBee (https://www.investorbee.com) gives a nice tool for working out asset allocations depending on a simple risk profile questionnaire.
Should be useful for most investors.
@dylantgerabbit, why not build your Dividend stock portfolio now ? Traditional asset allocation and the 4% rule create a scarcity mindset because your withdrawing assets. The future for inflation rates, ROI is unknowable. A prolonged bear market with 50% drawdown and 4% withdrawal can quickly deplete a portfolio built over a lifetime. A cash flow model based on dividend income and/or rental properties is what I am constructing. When cash flow > expenses I’m free and most importantly I am not selling assets.
I feel that figuring out the goal is only half of the battle in this day of age.
Asset allocation (in its overly-generalized form) used to be simple: (i) mostly equity, risky but juicier returns (ii) with bonds to balance the portfolio in a downturn and (iii) cash to buy the dip. With equity valuation at an incredibly high level and bond prices falling (and US yields rising), which we have seen in the past few weeks, nothing seems safe. Even a balanced asset allocation cannot seem to be a good enough hedge in the current environment. I’m simplifying but you get the point.
@The English Investor – after a decade long Bull market pumped up by trillions in QE inflating the value of assets, should we be surprised?
Which assets would do well in the phase between the end of QE/very low interest rates and the following panicky cuts to interest rates? What will do well after those panicky cuts?
And why wouldn’t both be “in the price” anyway?
@Brod
You are right. We should not be. QE distorted the economics and delayed the next downturn (those usually happen every 8 years or so, we are now overdue). Yet, it won’t prevent people from acting surprised.
My concern is that banks are pretty good now at booking and offloading risks. Yet the risk has not vanished. It is simply held by asset managers, ETF providers, and pension funds. Those groups – and the individuals they represent – may have a rude awakening when the music stops. I’m not trying to be over-pessimistic, some people will make money but it won’t be the majority.
@all — You’re entitled to have your opinions about the market (I certainly do, with my active hat on) and QE (FWIW I don’t agree with yours) but this is a passive investing article and they’re wildly off-topic for this article so let’s leave it there please. 🙂
Less knowledgeable readers should note that everyone from anonymous Internet posters to bloggers (including me!) to heads of Central Banks have a poor track record of prognosticating market and economic downturns, and take all this with a punch of salt.
“A cash flow model based on dividend income and/or rental properties is what I am constructing.” What is the maximum cut in dividends and rents that you include in your model? 50%?
Put otherwise: is a reasonable goal to aim to generate about twice the flow of income that you reckon you’ll need in retirement? Or would that be too unforgiving a goal?
@dearieme, 1.5x should suffice and with respect to the Investor I wont comment further as article is about Asset Allocation, Suffice I refer to the first Monevator article that I read and my favourite on Feb 15, 2008 “The one number to beat if you want to retire early”.
@jon — Cheers for your thoughts, and I think they’re on-topic for this article. You’ve clearly decided on your long-term investment goal, and you’ve build a portfolio towards meeting it. 🙂
My concern with the other comments and their usefulness for readers of this post is they are expressing almost the opposite mindset of this article — short-term thinking about prices and valuations that most people at least have little insight into (those particular commentators might be rare exceptions, who knows, that’s not the point for me as comment moderator 🙂 ).
Unless you’re investment goal is “to have a fund that speculates on short-term hunches about markets” this is not the way to think about the bulk of your long-term asset allocation. (I say ‘bulk’ because I think everyone can have a 5-10% ‘speculation’ pot if it helps them invest the rest in a structured and long-term fashion. 🙂 )
It is odd how we think we know things when a little reflection shows we can’t. It is easy to focus on one thing, QE, risk of inflation, “over priced US market’s or something and then let that direct your actions. Am I smarter than all those people investing in the US market or buying bonds? In my case worry about inflation is a bias, but what about the deflationary pressures of unserviceable debt or aging populations? Diversify. As someone said, you are not diversified until you own stuff you would rather not have. Ive got p!entry of that!