We have been discussing the asset allocation decision, which in its simplest form consists of how much of your investments you should expose to the higher risks and potentially higher rewards of the stock market, and how much you should keep in safer investment such as bonds and cash.
First, we established that this decision is the most important investment decision you will make. Many studies have shown that about 90 percent of the variability of returns between portfolios comes from asset allocation, leaving only 10 percent to be determined by the specific investments you choose. Therefore, you need to give the asset allocation decision the thought and study it deserves.
Next, we established that almost everyone should have at least 25 percent of their investments in equities, and under some circumstances it might be advisable to have 90 to 100 percent of your investment in equities. Therefore, the asset allocation decision consists of deciding how much of your investments to risk in the stock market, with 25 percent as the floor and 90-100 percent as the ceiling.
Finally, to guide you in making this important decision we introduced the risk assessment framework, written about by Larry Swedroe, in which you answer the following three vital questions to help you make the decision:
- How much risk do I need to take?
- How much risk is wise for me to take?
- How much risk am I willing to take?
Making your asset allocation decision is more art than science. I don’t have a simple equation that will provide the exact right answer for you. Indeed, there probably isn’t just one “right” answer. However, if you have answered the three questions above you are ready to put them together to come up with a good answer for you. A couple of case studies will make the process clear.
Case Study I – Bill O’Reilly:
Bill O’Reilly is the host of the political commentary show The O’Reilly Factor on Fox News, which has been the number one rated cable news show for over a decade. He has also written several best-selling books. He is 64 years old.
Although it might be fun, I don’t spend a lot of time hanging out with the rich and famous and advising them on their investments. Therefore, I found it fascinating to get a glimpse inside O’Reilly’s asset allocation strategy during an interview he had several months ago with Maria Bartiromo, a Fox News Business anchor.
In the interview O’Reilly and Bartiromo were discussing the stock market. O’Reilly complained that four times during his investment lifetime the market had taken steep nosedives.
Bartiromo could have pointed out that each time the market tanked it came back even stronger than before, and at the time of the interview it was at or near an all-time high. She could have pointed out that the only way O’Reilly could have lost money during the four nosedives was is if had panicked and sold when the market was down. She could have pointed these things out but instead she held her peace and let O’Reilly vent.
O’Reilly ended the interview by saying he was done taking risk in the market, and that for him 25 percent in stocks was enough. Let’s look at O’Reilly’s asset allocation in light of Swedroe’s risk assessment framework and see if he is right.
- How much risk does O’Reilly need to take? O’Reilly had a humble upbringing and undoubtedly met any financial goals he might have had long ago. He definitely doesn’t need to take any risk to meet his financial goals.
- How much risk is wise for O’Reilly to take? At 64 years old O’Reilly’s investment time horizon is not that long, and getting shorter every day. At that age most of us should be making our asset allocation more conservative in preparation for retirement. Indeed, the years just before and just after retirement carry the greatest risk of suffering permanent losses to you nest egg if you are too aggressive. However, since we are assuming O’Reilly has more than enough money for any conceivable personal needs, he is essentially investing for his heirs or for charity. In that case his time horizon is very long, and it would be wise for him to take a considerable amount of risk.
- How much risk is O’Reilly willing to take? It is obvious from his interview with Bartiromo that O’Reilly is extremely risk averse. He cannot handle the volatility of the stock market. If he were to take more risk than he is comfortable taking the likely result would be panic and poor decisions the next time the markets tank.
So how much risk should O’Reilly take? If I were advising him I would not argue with his assessment that 25 percent exposure to the market is enough. Although it might be wise for him to take more risk, he doesn’t need to take more risk. By saving more than enough to provide for his needs he has earned the right to be conservative and sleep well at night.
Case Study II – Bill O’Reilly’s Alternate Life
Early in his life O’Reilly taught high school English in Florida for a couple of years. Let’s imagine he had stuck with teaching and never became a political commentator (a thought that brings smiles to the lips of liberals everywhere). As long as we are imagining things, let’s also imagine that the alternate Bill O’Reilly is 50 years old. Now, how much risk should he take?
- How much risk does the alternate O’Reilly need to take? In all likelihood, the school teacher O’Reilly at the age of 50 would still need to take significant risk to reach his financial goals and provide for a comfortable retirement.
- How much risk is wise for the alternate O’Reilly to take? The school teacher O’Reilly at 50 years old would have an extremely stable income and an investment time horizon of at least ten to fifteen years. These circumstances would make it wise for him to take quite a bit of risk.
- How much risk is the alternate O’Reilly willing to take? The school teacher O’Reilly has the same risk characteristics as the rich and famous O’Reilly. He still can’t handle the volatility of the stock market and he still doesn’t want to take much risk.
There is a conflict between how much risk the alternate O’Reilly wants to take and how much risk he needs to take. An asset allocation of only 25 percent in stocks is probably not enough for him to reach his goals. What would I advise him to do?
I would advise the alternate O’Reilly to explore the upper limits of his sleeping point. It might be wise for him to have 80 percent of his investments in stocks, but this is clearly too much risk for him to handle. Instead, I would try to get him to agree to a long-term strategy of 40-60 percent in stocks. A Lifecycle type fund, where stocks, bonds, and cash are lumped together and reported as a single gain/loss appear to be less volatile and are sometimes easier for the risk averse to stick with.
You should now have a good idea how to use your unique circumstances, as reflected by your answers to the three vital questions, to establish a long-term asset allocation strategy. Your job now is to make a personal asset allocation plan and stay the course. Good luck and happy investing.