(This is part two of a three-part series on how I invest my nest egg. Part one on Diversification is here.)
Part Two: Asset Allocation
I learned the hard way about risk tolerance.
When I retired, I had 70% of my portfolio in stock funds (a mix between U. S. large, medium and small cap, foreign emerging and developed markets, and a small dose of REIT and commodity funds), and 30% in bond funds and cash.
In 2008 the S&P 500 Index fell 37%. My own portfolio fell 28%. In retrospect, that may have been an overly aggressive mix for my individual risk tolerance. Sometimes it’s hard to know exactly what your own tolerance for risk is until you’ve lived through a recession that tests it. Lesson learned.
When I talk about asset allocation, I am not talking about a method of investing that will achieve the highest returns. I am talking about an approach that matches your investments with your own individual tolerance for risk.
For those that don’t know, risk tolerance is defined as how much you want to kill yourself when you see your nest egg shrink.
I am not advocating any specific mix of investments. That’s for you to determine after you decide how much risk you are comfortable with. There is an old rule of thumb that says you take your age and invest that percentage in bonds and the difference between 100 and your age and put that percentage in equities. That’s a little conservative for me, but if it matches your risk tolerance, that’s what you should do.
A person that is a very aggressive investor might decide on a portfolio that includes 80% equities and 20% fixed income. In my early working years, when I had a long time-horizon and a steady paycheck, this was my risk-profile. An aggressive portfolio would be expected to achieve pretty high returns over the long haul. But a this point in my life, the year-to-year swings of that portfolio would have me slitting my wrists way too frequently.
Slide to the other end of the spectrum, and an 80/20 split in favor of bonds over stocks would involve a lot less volatility. But I am willing to assume a bit more risk to achieve a higher return. It’s all about what gets you to your goal while allowing you to sleep at night.
Here’s another way to look at risk tolerance. Each time I get in my car to go to the grocery store, to visit a friend, or to head to the movies, I’m taking a risk that one of those crazy tailgaters is going to kill me. But I assume that risk because it’s not that likely, and the reward: food, companionship or entertainment, outweighs my perception of that risk. I can tolerate that level of risk. Contrast that to sky diving. The reward of having that experience is not at all attractive to me, so I’m not willing to take on the risk of splattering to my death, however small it might be.
You can poke around on the Internet and find suggested portfolio allocations for various levels of risk tolerance. Here and here are a couple examples. Or, if you need more guidance, you might meet with an investment advisor who can help you determine your own risk profile before designing your specific portfolio.
By allocating your portfolio among various asset classes, you have basically decided that you are not going to try and predict winners or bubbles. You have decided to target the least amount of risk for the return you are trying to achieve. Some might even say you have decided to be lazy, I’ll accept that characterization too (although the rebalancing part, up next, requires a little action on your part.)
Up next : Periodic Rebalancing
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