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

What caught my eye this week.

One way to tell when someone is bluffing is when they rabbit on and on. I got that sense watching Philip Hammond’s Budget on Monday.

Oh, I don’t think he was being deceitful as such – although he did do the standard Chancellor sleight-of-hand trick by not revealing a National Insurance hike (see below) while boasting he was cutting taxes.

I also recognise his need to pepper his speech with dad jokes. Nobody wants to be known as Spreadsheet Phil, and Hammond has spent all his Budgets trying to shake that off that putdown with his Open Mic for MP gags.

But as the speech ticked past the hour mark, I sensed he really was making something out of nothing.

Rarely has so much been said by one chancellor for so little consequence to the status quo for the many, or the few.

Perhaps he was trying to bore MPs into backing a Brexit deal so they wouldn’t have to sit through an emergency Budget in March?

At least he didn’t tamper with pensions or ISAs.

• Summary of Budget 2018: Key points at-a-glance – BBC

• Are you a Budget winner or loser? Do the maths! [Calculator] – via Investors Chronicle

• More Budget-in-brief coverage – ThisIsMoney / Guardian / BBC

• Sneaky National Insurance hike may take back some of your tax cut gains – ThisIsMoney

Was there anything in the Budget small print that caught your eye?

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What caught my eye this week.

There are many things I do because I am an investing maniac that you probably shouldn’t.

For starters, I invest actively. That’s why I coaxed in my passively-pure co-blogger to keep Monevator on the straight and narrow.

Here’s another crazy notion of mine – I want to be able to live off my capital.

I don’t mean reach some lump sum that I then dwindle down to nothingness while eating grapes and watching Loose Women.

I mean replace a notional salary with an investment income that exceeds it, generated from an otherwise unmolested portfolio.1

This is a pretty quixotic goal on multiple fronts, as some of you have pointed out over the years.

First, it means I need a lot more money amassed before I can declare I’m financially-free on my terms. Not planning to spend the wodge down to zero has a big impact.

Second, I don’t plan at this point to ever entirely stop working for money. So my notional salary will be topped up by some kind of continuing income for years to come, making it all an even weirder modus operandi.

Third, I don’t have kids, have never aspired to, and it’s now looking unlikely I ever will. So there will be no official heirs to leave a woefully under-taxed inheritance to – only friends, relations, and the metaphorical dog’s home.

Really I should plan to spend the lot on Wine, Women, and Whatever – feel free to re-jig for your own sexuality and alcoholic tastes – and go out with empty pockets. Perhaps I will, but it’s not a goal I have in mind.

But for me, investing isn’t really a means to an end, it’s a means to a means.

When I tell people I don’t care much about money, they raise their eyebrows, given my passion for markets – and this site. Obviously on some level I do care about money, but really even spending it is not what motivates me.

I seem to find it all a big game and a passport to self-purpose. In my head I am a bohemian and I lived like a graduate student for decades despite having increasingly chunky assets because I liked it that way. I rarely judge people for not being able to save as I have, because frankly I found it no hardship.

But most people – even most of you – aren’t like that. You’re investing because you have to. You want to be able to retire in comfort, sooner or later, and perhaps have more to spend along the way. You have kids you’d like to help out. You hate your job and want to be free.

Remix to suit.

Who’s weird, anyway?

What you might not realize is that people like you have puzzled economists for decades.

Indeed, even though some of what I’ve written about myself above probably seems a bit out there, lots of people – especially in the US but increasingly here too since the advent of the pension freedoms – are arguably just as irrational.

The reason – the puzzle – is why most people don’t buy annuities when given the choice?

Theoretically annuities maximize the amount of spending you’ll potentially be able to do in an average retirement. This is because annuities spread the risk of any particular retiree outliving their savings among many retirees.

The alternative – to self-insure against a telegram from the Queen – is an expensive option.

I suspect people don’t buy annuities because the thought of being hit by a bus the next year and leaving an annuity company hundreds of thousands of pounds up on the deal is eye-watering.

But that risk is the price you pay for not running out of money – and for probably spending more than you would have in that year until the bus comes. Your sadly early demise keeps somebody else having fun at 100.

Also, as you’d be dead, who cares?2

I won’t hash it all out here because Victor Haghani of Elm Funds has done a great job for us.

In a post succinctly entitled The Annuity Puzzle, he makes a few simplifying assumptions and then offers the following graph:

The blue bars shows a consistent and high spend from an annuity. The red bars show what happens if you have to make sure you don’t run out of money.

It’s a pretty compelling image, presuming the maths checks out. As I say, assumptions are made. Your mileage may vary.

One thing that probably isn’t a valid criticism of the pro-annuity argument though is that annuity rates are too low. If rates are low it’s probably because expected returns from other investments are (in theory) somewhat lower, too.

And low expected returns don’t have anything to do with longevity risk, anyway.

I’m no expert on annuities – they still seem far away so I’ve not crunched the numbers for myself. Friend of the site and IFA Mark Meldon wrote a great post on annuities back in May, so check that out.

And of course you can see all our articles on deaccumulation for the other side of the argument, such as this one from The Greybeard.

You should also read the full article at Elm Funds.

I’ve long thought I’d buy an inflation-linked annuity to cover my basic income floor. Beyond that I’d be the oldest Wolf of Wall Street on the block, and maybe die as one of those mystery millionaires you read about who hoards supermarket vouchers. (Albeit from Waitrose or Whole Foods!)

But what about you?

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1. In reality I’d probably continue to tinker until senility sets in. But this would be the high concept. [↩]
2. I know, I know, your heirs and spouse. [↩]