There’s an irony in the world of personal finance: The activity that is the most entertaining—picking stocks—is also, according to the data, one of the most counterproductive. Meanwhile, making asset allocation decisions is more akin to watching paint dry, and yet—according to the data—that’s one of the most important decisions an investor can make.
Asset allocation refers to the split among your investments—how much you hold in stocks, for example, versus bonds or real estate. According to a well known study by Gary Brinson and colleagues, asset allocation drives about 90% of the results of a portfolio. In other words, for all of the time people spend debating which stocks or which mutual funds to own, the reality is that those decisions are responsible for just a minority of an investor’s results. In contrast, the vast majority of investment results—and thus, the most important decision—hinges on just a single question: how a portfolio is allocated.
In the past, I’ve outlined the process I recommend for choosing an asset allocation. Investors should ask themselves three questions:
1. How much risk do I need to take? This helps determine the minimum amount that should be invested in stocks.
2. How much risk can I afford to take? This indicates the maximum that should be held in stocks.
3. How much risk can I tolerate from an emotional perspective?
For many people, the answers to these questions result in a fairly narrow range of advisable allocations. To ensure growth, they can’t afford to hold too little in stocks, and to manage risk, they can’t afford to hold too much. But for other investors, there’s a much wider range of possibilities. At the extreme, consider someone like Warren Buffett.
A while back, Buffett revealed the allocation he’d chosen for his family trust: 90% in stocks and 10% in bonds. The reality, however, is that because of the scale of his assets, he could have instead put 90% into bonds and just 10% into stocks, or chosen virtually any other combination. While none of us is Warren Buffett, this same dynamic does begin to apply as one’s portfolio gets larger. Asset allocation, in other words, becomes less about math and almost entirely a matter of personal choice.
If you’re in that position, it’s a luxury in some ways, but it also presents a challenge: In deciding on an asset allocation, it means there’s no easy answer. In fact, in contending with this question, investors often cite two opposing—but both entirely reasonable—philosophies: On the one hand, some reference author William Bernstein, who has famously said, “Once you’ve won the game, stop playing.” In other words, don’t take more risk than is necessary. On the other hand, more risk-tolerant investors will often say: “If I can afford to take more risk, why wouldn’t I? Why leave money on the table?” If this is a question you’re wrestling with, here are some approaches I’ve found most helpful.
Employ multiple lenses. If you’re trying to choose between an allocation of, say, 40% stocks or 60%, try converting those percentages into dollar terms. For each of the allocations you’re considering, look at the number of dollars you’d have in stocks and ask how you’d feel if the market declined by half, as it did in 2000 and in 2008. Next, consider the dollars you’d have in bonds and ask how long that might carry you if the stock market saw another big decline. Always look at the decision from more than one angle.
Recognize that there are many “right” answers. In fact, there are often more right answers than truly wrong answers. Continuing with the above example, if you’re torn between an allocation to stocks of 40% or 60%, recognize that either decision is more reasonable than going all the way to an extreme of either 0% or 100%. So don’t worry too much about getting to an answer that is precisely right. Instead, simply try to get to a decision that, above all, feels reasonable.
Avoid formula-driven answers. When it comes to asset allocation, there are a variety of rules of thumb. For example, there’s the dictum that an investor’s allocation to stocks should equal 100 minus his age. Others look to Modern Portfolio Theory to structure their investments. And while each of these might contribute to the mosaic, there’s no formula that can capture the full picture. That’s true especially because all formulas are built on assumptions about the future. Without the benefit of hindsight, then, it would be impossible for anyone to know the absolute optimal allocation.
Just as investment markets are unpredictable, so too are our own needs and goals. To understand this, consider my college roommate. Some years ago, he and his wife were expecting their first child. But they were surprised when the doctor let them know that they should get ready for not one but three children. Life can throw curveballs, and sometimes our preferences simply change over time. That’s a reason to leave a little latitude in whatever allocation you choose.
Just as our needs aren’t static, our mindset can change as well. Suppose you’re in your 50s or 60s and thinking about retirement. During your working career, you’ve seen more than one market downturn, so you know what it’s like to experience a reversal in your portfolio. The challenge, though, is that if you haven’t retired yet, then, by definition, you don’t know what it’s like to live through a downturn while in retirement. Retirees often report that downturns are a very different experience when they’re drawing on their portfolios rather than contributing. The solution? You might choose to be a bit more conservative with your investments than you’ve been in the past.
In the end, it’s important to realize that asset allocation is only partly a math problem. More than anything, it’s what I call an antacid problem. In settling on an answer, the question you really want to ask yourself is: What can I live with? That, I think, will lead you closer to the right answer than trying to divine what is precisely, mathematically optimal.