Every Investor Is Unique
No two clients have the same identical financial needs or goals. Since each investor is distinctly different from the next, their investments should reflect that uniqueness – to an extent.
For younger more aggressive investors, an asset allocation model with 90% to 100% in stocks (and the balance in bonds and cash) may be appropriate. For more conservative (think retired) investors, the risk profile and asset allocation becomes more difficult to determine.
For these investors, financial planning becomes the critical factor in asset allocation. In fact, I don’t know why anyone would put a dime into an investment without a financial plan driving the decision.
Conventional Wisdom Is Wrong
Conventional wisdom says something to the effect of “take 100 minus your age and that’s the amount of stock investment you should have”. Something so simplistic can’t be the best solution for every investor.
In fact, I’d argue it’s a horrible idea. The truth is there are three core components of your asset allocation strategy:
- Your risk tolerance – This is the first (and weakest) of the three. It’s a simple “I can stomach this volatility” measure. It completely disregards the next two – and more critical – components of any solid asset allocation plan.
- Your risk required – Who cares if you can stomach 90% in stocks? What if your ultimate financial plan has a higher confidence level at 50% stocks? You clearly have a choice between more and less risk. If less risk will accomplish all of your financial goals, why subject your finances to potential catastrophe?
- Your risk capacity – Finally, who cares about your risk tolerance or risk required if you can only weather a certain level of financial storm? For example, your financial plan may dictate a 70% stock allocation as your risk required to accomplish your goals. If however, your financial plan would be ultimately derailed with a 40% drop in your portfolio, your risk capacity won’t allow that level of aggressiveness.
And There’s Your Phase Of Life
While I love the risk required and risk capacity, each investor could start their asset allocation plan with a “phase of life” determination. For example, there are three main phases:
- Accumulation – Asset growth with high volatility is most appropriate. These are generally younger investors with more than 5 years until retirement. They don’t need to draw on their investments anytime soon, so the volatility won’t derail their financial future.
- Preparation for Transition – Preparing to transition your portfolio for retirement income. These are generally investors with less than 5 years until their ultimate retirement date.
- Decumulation – Using your investment portfolio for retirement income. These are fully retired investors who rely on their investment portfolio for a steady retirement income paycheck.
This may seem somewhat simplistic, but for our purpose it makes sense. There are three dominant financial stages of life after all: growth, transition to income planning, and income planning.
Within each of those three goals there are nuances for every investor. There’s also no “perfect” asset allocation for any investor, because all asset allocation models are based off historical risk and return numbers. These are however, useful as a starting point from which to plan from.
Remember: Asset Allocation Is Looking In Reverse
What I mentioned in the last paragraph is so important I’ll state it again. Asset allocation models look in reverse.
Asset allocation models are generally created from what we can an “optimizer”. These optimizers use historical statistics. They’re designed to balance the right amount of assets with each other to give investors the lowest amount of volatility for the greatest amount of return at each risk/return profile level.
“Optimized” asset allocation models are only as good as the historical information is accurate. Assuming that the future growth and volatility will have some resemblance to the past, optimizers are the best starting point.
Remember, optimizers are like driving backwards using the rear view mirror for vision. It’s hard at best! Slight deviations at the wheel have huge consequences if you’re going to fast!
Retired Clients Have To Think Forward
Regardless of what phase of retirement you’re in, you still have another 5 year period to plan for. My 97 year old grandmother still has another 5 years to plan for. Planning for anything other than that would be imprudent.
The 5 year rule is important because so many retirees allocate into an overly conservative portfolio, thinking they can’t risk losing money. In reality, their largest risk is losing purchasing power from inflation pressures.
A stamp in 1980 was .15, today it’s .44. A gallon of milk today is $4, in 20 years it will be $10.
Retired clients need to focus on maintaining standard of living more than short term volatility. They need to be able to buy that same gallon of milk in 20 years that they do today for $4.
So keep in mind your true timeframe and what your true risk is. I’d venture to guess it’s not market volatility, it’s the guaranteed loss of purchasing power from inflation over your lifetime!