Friday, September 25, 2009

Asset Allocation: Part 4 – Risk Tolerance

In Part 2 of this asset allocation series I assumed 25% allocations for each asset class in the example portfolio. Selecting the target asset allocations for your portfolio is not a science – despite the “Risk Tolerance” surveys and formulae offered by many financial planners.

There are some basic concepts you should consider when setting asset allocations:

1. The closer you are to retiring the greater the allocation of your total assets to “safer” asset classes and the lower your allocation to “risky/aggressive” asset classes.

2. Money you expect to need within the next five to ten years (depending on which financial planner you listen to) should be held in cash or cash equivalents; money market funds, Bank CD’s (certificates of deposit), or laddered bonds (not bond funds).

3. A large enough allocation must be made to more aggressive asset classes to keep up with inflation because the average woman who retires at the age of 62 will live another 25 years; the average man another 20. Many will live 30 years after retiring and some will live 40. In 30 years even moderate inflation rates can be devastating to the value of your portfolio.

4. Emergency funds must be held in cash or cash equivalents that can be withdrawn quickly without penalties.

5. If allocations are too lopsided in favor of any asset class rebalancing will have little value.

6. You have to sleep at night. If your investments keep you from sleeping change your allocations to favor safer asset classes.

Planners advocate allocation plans that vary all over the place. I’ve read advice for twenty-somethings to be 100% in growth stocks. At the other extreme, I’ve seen advice that everyone, regardless of age, should be 50% in stocks and 50% in bonds.

Here’s my advice:
1. Have some money in cash, have some money in bonds, have some in stocks, have some in gold, and have some in real estate. Each of these asset classes should be at least 10% of your portfolio value and none should exceed 70%.

2. Your emergency fund is not part of your portfolio. It should be 100% cash and not count as the cash portion of your portfolio.

3. If you are within five years of retiring you should start building up the cash portion of your portfolio so that on the day you retire you will have enough cash in your portfolio to cover your expenses for five years – after subtracting expenses you plan to pay with money from Social Security, a fixed pension, or income from an annuity.

4. Within these constraints, design your portfolio to grow to meet or beat inflation not counting the new money you will invest – but with asset allocations that let you sleep at night.

5. Rebalance your portfolio annually – perhaps around your birthday.

6. Reconsider your asset allocations annually. You’re getting older and you may be getting wiser.

Risk tolerance and setting asset allocations is more art than science regardless of the research and the formulae used by financial planners.

Links to other Topics in the Special Report: Asset Allocation

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