An Easy Guide to Picking Your Perfect Asset Allocation

In conversations with my coworkers during our transition to Vanguard, I was amazed at how dangerously out of whack their asset allocations were. Some older employees had way too much risk in their portfolio for their age and living situation, while other young workers had all of their assets in a money market account, or previous default setting, and let inflation eat away at their buying power.

I stressed to them, as I now stress to you, the importance of picking a good asset allocation. And it’s easier than you think.

What is asset allocation?

Simply put, asset allocation is how you divide your investments among different asset classes – stocks, bonds, cash, real estate, precious metals, collectibles, etc.

As you no doubt already know, risk and reward are inextricably linked. The higher the risk, the more reward.  The lower the risk, the lower reward. In investing, different asset classes come with different risk levels. Stocks, precious metals, collectibles contain more risk, whereas bonds and cash are less risky.

The point of asset allocation is to find the mix that gives your portfolio the best chance to succeed based on your risk tolerance.

Risk tolerance is key to your allocation

I need to repeat the last part of the previous sentence: based on your risk tolerance.

Risk tolerance is a hard thing to define. And as Burton Malkiel points out in his book A Random Walk Down Wall Street, you need to take into account both your attitude toward risk (e.g., how you feel about the possibility of losing 45% of your portfolio in one day) and your capacity for risk (your ability to sustain a loss of 45% of your portfolio in one day).

For example, a 70 year-old widow who lives off of social security and her portfolio income may have a fearless attitude toward risk, but, because of her situation, doesn’t have the capacity to withstand much fluctuation in her finances. Conversely, a 30-year-old doctor may have some hesitation towards risk, but, because of her earning capacity and job stability, she may have more of a capacity for risk.

Balancing these two options should help steer how much of your portfolio you want in stocks and other riskier assets and how much you want in safer assets like bonds and money market accounts.

Start with your age

To be fair: there’s not one perfect asset allocation.  As I stated above, factors such as your risk tolerance, earning potential, and other assets all play a role in how you pick your allocation. However, as a simple starting point, many advisors suggest beginning with with your age.

The rationale behind this thought stems from your ability to reduce the risk of your entire portfolio by holding the investments for a longer period of time and dollar-cost averaging (i.e., investing a fixed amount of money on a continuous basis). The holding period reduces risk because over the years you have the ability to balance the variation of your returns. And dollar-cost averaging helps you avoid putting all of your money in the market at the wrong time.

In short, other things being equal, the longer you have to invest the more risk you can take.  Therefore, if you have a 30-year investment horizon, you can save more in riskier investments like stocks, while leaving a smaller portion of your portfolio for safer investments like bonds. As you age, you should adjust your ratio accordingly to accommodate the shorter time frame until you need the money.

John C. Bogle, index investing guru and founder of Vanguard, provides an even easier,  practical application to using your age as a starting point for your asset allocation. He suggests that your age should equal the percentage of bonds in your portfolio. Thus if you’re 35, you should hold 35% of your portfolio in bonds and 65% in stocks. On the other hand, if you’re 70, you should have 70% in bonds and 30% in equities.

Alternatively, some advisors suggest, because people live longer in retirement, that you should take 110 or 120 minus your age and use that number as your stock allocation. So a 35 year old would have 75% or 85% of their portfolio in stocks.

Don’t forget to fine tune

As I said, age merely serves as a starting point. I can’t emphasize enough that you need to consider your risk tolerance and life circumstances (such as job security or available liquid assets). You hurt yourself if you overestimate your risk tolerance or capacity for risk and find yourself selling everything when the market has tanked, as it did in 2008.

Make sure to tweak your allocation to match your personal circumstances.

The power of rebalance

One last tip on asset allocation: your stock-to-bond ratio may become a little skewed over time because of the performance of your different investments. So consider rebalancing to make sure your ratio matches the asset allocation you intended.