Asset Allocation = Peace of Mind

Recently I had the opportunity to ask a new client what was the primary reason for their selection of a new registered investment advisor (RIA). Their answer surprised me. Both husband and wife described their lack of comfort in having an asset allocation plan forced on them by their former advisor who maintained that a heavier weighting in stocks versus bonds “was the only way to invest.”

For a new client/advisor relationship to work, both parties must work together to craft an investment policy statement that clearly establishes rules, boundaries, expectations, strategies and guidelines for all advising work going forward. The foundation of this policy statement is a strategic asset allocation plan or risk profile that delineates the percentage of assets earmarked both for equities (capital appreciation) and fixed income (income generation).

What risk profile is most suitable for you and your family? Do you consider yourself to be a conservative (less than 20% equities), balanced (50% equities and 50% fixed income) or aggressive (over 80% equities) investor? To answer this question, most clients must consider how their peace of mind is affected by volatility in the financial markets. What is my threshold for pain or said another way, when will stock market losses keep me up at night?

A simple rule might be that if you were to subtract your age from 100, your answer could be the equity percentage of your portfolio. Thus at age 52, my equity percentage might be 48%. (My current risk profile is 40% equities, 55% fixed income and 5% cash.) This is overly simplistic, but it demonstrates the point that for most investors, age and portfolio equity percentage are inversely related. The shorter our investing time horizon (or when we need our money), the less risk we should be willing to accept in our portfolios.

What most clients do not understand is how their asset allocation plan effects returns over the long term. It may surprise some readers to learn that a conservative portfolio will return, on average, 8.20% per year while the aggressive portfolio will return only slightly more at 9.70%. The real difference in returns is that the conservative investor sees a one year high return of 22.80% and one year low return of -4.60%. Alternatively, the aggressive investor sees an impressive one year high return of 39.90% and disappointing, head scratching one year low return of a -36.00%. Thus, what asset allocation does is smooth out expected returns by lowering the probability of the real high peaks and real low valleys. What may be left on the table during the strongest of bull market is saved from destruction during the next correction or mean bear market. To me that translates into peace of mind.

So what does this mean to you? Your risk profile or asset allocation is about what is right for you and your family. Choose an asset allocation that fits your goals and objectives and gives you peace of mind. If it properly and appropriately balances risk and reward for you and your circumstances, then it works.