We’ve observed over the years that many investors sometimes forget some simple yet key concepts that are important in the asset allocation process. Some of these are quite basic, others are more sophisticated:
What is your investment horizon?
Will you need to liquidate a material portion of your portfolio over the short term (five years or less), or can you leave the principal invested for the longer term? You may need to use some income, appreciation, and even a bit of capital on an annual basis, but that doesn’t mean you have a short-time horizon. Many retired investors think they have a short investment horizon, when in fact they must make their money last 10 years, 20 years, or even longer.
How much risk can you afford to take?
This is driven partly by how close you are to meeting your investment objectives. If you are very wealthy and will never be able to spend everything you have accumulated, you have the best of both worlds. On the one hand, you can afford to take quite a bit of risk without jeopardizing your lifestyle. On the other hand, you could also keep risk very low because you don’t have to take added risk to create higher returns. In this situation you can decide solely on the basis of your comfort level. If you are young and have many years to invest, you can, and probably should, invest aggressively. Over the long term this usually pays off, and the short-term risks wash out. On the other hand, if you can meet your goals without taking much risk, then a more conservative stance makes sense, especially if aggressive investing gone sour could jeopardize your goals. The process of quantifying how much risk you can or should take to meet your goals is more complicated than most people realize. The most important thing to remember is that the longer your time horizon, the more risk you can tolerate.
What is your psychological tolerance for risk?
This question is different from the last one. While you may have a long time horizon or plenty of capital (so theoretically you are able to take a lot of risk), short-term volatility may not be psychologically tolerable. In other words, an aggressive approach simply won’t pass the sleep test for some investors. One way to determine your short-term risk tolerance is to think about how big a loss you could take on your whole portfolio (not any particular piece) in any one year and stay relaxed. Could you sleep through a 5%, 10%, 20%, or 30% decline? Of course the real issue is not actually your sleep, at least not from an investment standpoint. The real issue is whether your psychological intolerance for losses will cause you to sell at the most inopportune time—after a short-term loss, and no longer able to use a long time horizon to your advantage to compensate.
Evaluating your return objective is the flip side of the risk question.
Though all investors would like to maximize return and minimize risk, it doesn’t work that way. Higher returns are usually accompanied by higher risk and vice versa. Nevertheless, determining the return you need to meet your goals helps you assess the trade-off as to whether the accompanying risk level is acceptable. If the trade-off is not acceptable, you will have to either lower your return objectives, save more, or increase your risk tolerance (not easy to do).
Setting objectives is one thing, determining if they are achievable is another.
Returns have varied over time. In the 1950s stocks earned almost 20% on a compounded annual basis. However, in the 1970s they earned only 5.9%. Intermediate government bonds made only 1.3% in the ’50s, but earned an 11.9% return in the ’80s.
In the real world, investors can diversify more broadly among potentially higher-returning asset classes such as different investment styles (growth or value), different market caps, international funds, high-yield bond funds, and REIT funds. These additional asset classes create the opportunity to enhance returns, often without increasing risk. Developing a historical frame of reference to understand how stocks and bonds have performed over time is an important starting point for any successful investor. [Understanding how the current environment differs from the past is another essential consideration.] Even more important is your ability to come to grips with your time horizon, risk tolerance, and return objectives. These are the critical ingredients to assessing which portfolio strategy is for you.
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