The fundamental law of investing is that there is no reward without risk. The corollary to this law is that your most important investment decision is how much risk to take.
Definition of Asset Allocation
How you divide your assets between safe and risky investments is known in investment literature as Asset Allocation. Popular investment author Bill Schultheis defines asset allocation as “…dividing up your assets in the right proportion among stocks, bonds, and cash to maximize your chance of achieving your financial goal with the minimum amount of risk.” For practical purposes asset allocation involves deciding what percentage of your investments to expose to the higher risks (and potentially higher rewards) of the stock market, and what percentage to keep in safer assets like cash and bonds.
How Important is Asset Allocation?
How you allocate your resources between stocks and safer investments is essential to your investment success. How essential? David F. Swensen, in his classic investment book Unconventional Success: A Fundamental Approach to Personal Investment, states “A number of well-regarded studies of institutional portfolios conclude that approximately 90 percent of the variability of returns stems from asset allocation, leaving approximately 10 percent of the variability to be determined by security selection and market timing.”
In other words, the decision regarding what percentage of your investments you expose to the stock market is about nine times more important than the specific stocks you buy, or when you buy and sell them. In fact, for most people the asset allocation decision is one of the most important financial decisions they will make.
Have you given this vital decision the time and effort it deserves? There is strong evidence that many people have not. John Boggle reports, “Nearly 20 percent of 401(k) investors in their 20s own zero equities in the retirement planning, holding, instead, outsized allocations of money market and stable value funds, options that are unlikely to keep pace with inflation as the years go by. On the other end of the spectrum, more than 30 percent of 401(k) investors in their 60s have more than 80 percent of their assets in equity funds. Such an aggressive allocation likely resulted in a decline of 30 percent or more in their 401(k) balances during the [recent] bear market, imperiling their retirement funds precisely when the members of this age group are preparing to draw upon it.”
Bogle focuses on the extremes but many others have their investments allocated in ways that don’t make a lot of sense given their unique situations. Are your investments allocated to “maximize your chance of achieving your financial goal with the minimum amount of risk?” When was the last time you seriously examined how your assets are allocated? Perhaps it is time to reconsider this most important of investment decisions.
How Much Risk Should You Take?
Legendary investor Benjamin Graham believed that everyone should allocate a minimum of 25 percent and a maximum of 75 percent of their investments in stocks. I believe, under certain circumstances, it is wise for some people to raise the percentage invested in stocks to 90, or even 100 percent. Your decision, then, is to decide what percentage of your investments you will expose to the stock market, with 25 percent as your floor and 100 percent as your ceiling.
What level of risk is right for you? As with most important decisions there is no easy answer. However, there are online risk assessment tools that will give you a quick and easy estimate. My favorite is on Vanguard.com. This tool only takes about five minutes to use and it will return recommendations of specific Vanguard funds to invest in. Give it a try. I don’t think, by itself, it is sufficient, but it is a good place to start.
Three Vital Questions
Determining what level of investment risk is right for you is important enough to merit more thought and effort than merely answering a few questions online. In my reading on the topic I have been most heavily influenced by the ideas of Larry Swedroe. In his book, The Only Guide You’ll Ever Need for the Right Financial Plan, Swedroe presents a framework for answering this question that is simple and easy to understand, but comprehensive enough to require deep thought about your unique situation and how it affects the amount of risk you should take.
Swedroe does this by breaking the topic down into three areas and asking a question about each. While I have changed some of his terminology the framework is Swedroe’s. I have termed these the three vital questions on risk. They are as follows:
- 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?
Answering these three vital questions will prepare you to answer the larger question of what percentage of your investments to expose to the stock market. In my next three posts I will address each of these questions in turn. Answering these questions will take some thought but getting the asset allocation decision right will be more than worth the effort.