I’m sure I sound like a broken record when I say that the single most important part of an investment plan is asset allocation. While nothing in the world is guaranteed, you dramatically increase your chances for success when you have an effective mix of stocks, bonds, cash and maybe real estate.
But this is easier said than done. How exactly does one choose the right mix? There are a number of ways to answer this question: There are rules of thumb based on age, there is a statistical approach called Modern Portfolio Theory, there are risk tolerance questionnaires and there are cash flow-based approaches. Each, of course, will provide a different answer—and for good reason. Each approach emphasizes different factors.
But what if the answers differ dramatically? For example, it’s not uncommon for a strictly mathematical analysis to result in an asset allocation of 100% stocks. Meanwhile, if that same person were to fill out a more qualitative risk questionnaire, the result might be more conservative.
So what should you do if the math says one thing but your stomach says another? If the math says you can afford an all-stock portfolio, should you do it? Should math trump emotion, or the other way around? Here are five considerations to help think through this question:
1. All math involves assumptions. If the math says your portfolio can afford maximum risk, ask yourself what assumptions underlie that calculation. In particular, what assumption are you making about the stock market? If you look back at U.S. stock market history, downturns generally result in losses of 20% to 50% and last two to four years. But notice that I said generally. In the Great Depression, the market dropped more than 80% and didn’t fully recover for more than a decade.
2. Just because something hasn’t happened recently—or hasn’t happened here—doesn’t mean it can’t happen. To be sure, the Great Depression was a long time ago, and the stock market now has systems in place to help prevent a crash of similar proportions. But no one really knows, and you shouldn’t write off the 1929 crash as ancient history. Consider Japan, for example. In 1989 it was on top of the world. Their economy and stock market were soaring, but in the subsequent two decades, the Japanese market declined more than 80%. Even today, nearly 30 years later, the Nikkei index stands 46% below its peak. A sober reminder, if ever there were one, that unexpected things can happen.
3. Your needs might change. Suppose you do the math and determine that your asset allocation is robust because you have five years of spending money set aside in bonds and cash. In theory, that would carry you through a typical market downturn (other than the Great Depression). But what if something happened—a health issue, for example—and your expenses increased? These kinds of things are impossible to predict, but I think it makes sense to allow for the unexpected when structuring your finances.
4. You might not know your true tolerance for risk. If you haven’t lived through a 50% market downturn like the U.S. market experienced in 2000-2002 or 2007-2009, you might not have an appreciation for what it’s like. Or, more to the point, you may not know how you would react. It’s one thing to guess how you might react to a financial event; it’s another thing entirely to live through it. If you haven’t yet lived through a true bear market, when all the news is bad as far as the eye can see, then you might want a more moderate asset allocation than the math suggests.
5. It might be unnecessary. One day last summer, I found myself speeding through upstate New York. I had to get to a meeting, but when I looked at the clock, I realized I had plenty of time. I was racing for no reason and risking an expensive run-in with the New York State Police. So I immediately slowed down. If you’ve built up substantial savings, you may be in the same position—taking lots of stock market risk when it’s no longer necessary. If you have the risk dial set to 10, ask yourself whether you’re swinging for the fences when you’ve already won the game.