Asset Allocation and Risk Tolerance

The following is an adapted excerpt from my book Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less.

When putting together a portfolio, the first thing to decide is your desired asset allocation. That is, how much of your portfolio should be invested in each asset class (e.g., U.S. stocks, international stocks, and bonds)?

Your tolerance for risk is the most important factor in determining an appropriate asset allocation. The primary factors determining your risk tolerance are:

1. Your economic/financial ability to tolerate risk (i.e., how much risk you can afford), and
2. Your emotional/psychological ability to tolerate risk.

Your economic ability to handle risk is significantly impacted by the degree of flexibility you have with regard to your financial goals.

Financial Flexibility

Example 1: Jason is a construction worker. He’s 57, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered — but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.

Example 2: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $80,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $80,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a greater ability to take risk.

Comfort with Volatility

Your risk tolerance is also affected by your comfort level with volatility. One way to estimate this comfort level is to ask yourself, “How far could my portfolio fall before I started losing sleep, feeling stressed, or wanting to sell everything and move to cash?”

When answering this question, be sure to answer both as a percentage and as a dollar value — otherwise you may come to inaccurate conclusions. For example, you may remember that at age 25 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 10-times the size that it was at age 25, a 40% loss could be an entirely different experience.

When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative for your tastes, you’ll only be missing out on a relatively small incremental return.

In contrast, if you end up with a portfolio that’s too aggressive, you might end up panicking during periods of high volatility. Even one instance of getting out of the market after a sharp decline can be more than enough to eliminate the extra return you were hoping to earn from having a stock-heavy allocation.

Stocks vs. Bonds

Once you have an idea of your risk tolerance level, it’s time to move on to the first (and most important) part of the asset allocation decision: your stock/bond allocation.

One rule of thumb that serves as a reasonable starting point for analysis is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, said differently, assume that your stocks can lose 50% of their value at any time.

The most important thing to remember with asset allocation guidelines, however, is that they’re just that: guidelines. For example, with regard to this particular rule of thumb, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

U.S. Stocks vs. International Stocks

As you might imagine, the U.S. stock market isn’t the best performing market in the world every single year.

The difficulty in international investing — as with picking stocks or actively managed mutual funds — is that it’s nearly impossible to know ahead of time which countries are going to have the best market performance over a given time period. The solution? Own all (or at least many) of them.

The primary goal of investing a portion of your portfolio internationally should not be to increase returns, as there is no guarantee that international markets will outperform our own. Rather, the primary goal is to increase the diversification of your portfolio, thereby reducing your risk.

In total, the U.S. stock market makes up roughly half of the value of all of the publicly traded stocks in the world. (It varies over time, depending on how the U.S. market has performed recently relative to other markets.) However, for two reasons, most investment professionals recommend allocating more than 50% of the stock portion of your portfolio to domestic equities. First, international funds generally have somewhat higher expense ratios than domestic funds. Second, investing internationally introduces an additional type of risk into your portfolio: currency risk.

Currency risk is the risk that your return from investing in international stocks will be reduced as a result of the U.S. dollar increasing in value relative to the value of the currencies of the countries in which you have invested.

EXAMPLE: A portion of your portfolio is invested in Japanese stocks, and over the next year it earns an annual return of 8%. However, over that same period, the value of the yen relative to the dollar decreases by 3%. Your annual return (as measured in dollars) would only be roughly 5%.

So how much of your portfolio should be invested internationally? There’s a great deal of debate on this issue, with investment professionals recommending a very wide range of international allocations.

Without knowing how the U.S. market will perform in comparison to markets abroad, there’s simply no way to know what the “best” allocation will be. As with most asset allocation decisions, there’s a pretty broad range that’s reasonable. Allocating anywhere from 20% to 40% of the stock portion of your portfolio to international index funds would be reasonable for most investors—with the general idea being to give international stocks a somewhat smaller weighting than their (roughly) 50% market weight (due to their higher costs and currency risk), while still making sure that the international allocation is of sufficient size for it to offer a meaningful diversification benefit.

Rebalancing

No matter how perfectly you craft your portfolio, there’s little doubt that, in not too terribly long, your asset allocation will be out of whack. The stock market will have either shot upward, thereby causing your stock allocation to be higher than intended, or it will have experienced a downturn, causing your stock allocation to be lower than intended.

Rebalancing is the act of adjusting your holdings to bring them back in line with your ideal asset allocation. A periodic rebalancing program helps keep the risk level of your portfolio in line with your goals.

How often should an investor rebalance? That’s a tricky question. Some people advocate in favor of rebalancing once your portfolio is off balance by a certain amount (such as your stock allocation being either 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals (annually on your birthday for instance) regardless of how off-balance your portfolio becomes in the interim.

The best-performing rebalancing strategy varies from period to period, and it’s no easy task to predict which one will do best over the course of your investing career. Rather than spending a great deal of time and effort thinking about it, my suggestion is simply to pick one method and resolve to stick with it.

It’s worth noting that rebalancing can be quite difficult emotionally/psychologically. It can feel as if you’re selling your “good investments” to put money into your “bad investments.” The key is to remember that just because something has performed well (or poorly) recently doesn’t mean that it will continue to do so in the immediate future.

Simple Summary

• Your tolerance for risk should be the primary determinant of your stock/bond allocation. Your risk tolerance is determined by how much risk you can afford and how much risk you can tolerate psychologically.
• Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.
• For the sake of additional diversification, most investment professionals recommend investing somewhere from 20% to 40% of your stock holdings internationally.
• Rebalancing is the act of bringing your portfolio back to its targeted asset allocation (and, therefore, its targeted risk level).