Asset Allocation – Make It Your Own

Investments do better if you spread out your risks over various asset types. The goal of allocating to different classes is to have some that do well in good times and have others that do well in bad times. Having the best allocation can trump having the best specific investments in investment return over time.

According to the Securities and Exchange Commission Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing:

“Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”

Over the years, I’ve had a couple of investment ‘professionals’ attempt to guide me on what my asset allocation should be. I’ve also read a lot of books and articles that try to give advice. There are even online calculators that try to guide me on how to allocate my assets, such as this one from Iowa’s government site or this one from Bank Rate.

What none of these people or things know, however, is my total asset and income base (because I don’t share it) or my financial goals for the assets being allocated.

Most advice and many of the calculators are geared to weigh your age very heavily. For instance, with the bank rate calculator, entering age 21 vs age 66 with all other factors being equal (including the need for zero income) indicates that the 21 year old should have 96% of her assets in stocks while the 66 year old should only have 52%.

In addition, most advice and most calculators only include the mix of stocks vs bonds vs cash. We have (and you probably do as well) other types of assets as well.

Because we are over 60 and retired, most advice we get says to put lots of our assets in nice safe secure things like cash and bonds.  What they don’t know is that we live off current income and don’t need the principal from our investments and soon won’t need the dividends or capital gains either.  We are building long term family wealth to pass along to our next generations.  There is no way we want or need to be invested so conservatively!

How do you make an asset allocation model your own?

An asset allocation model merely shows you what percent of your assets to put into which asset categories. You set the percents and the categories based on your own goals.  Your goals may change from year to year and from life event to life event.

General economic conditions may affect your allocation. Your health may affect it. If you get married, have a child, move or get a different job, your allocation might be affected.

You can’t rely on professionals to do this for you, even if you are part of the uber rich. In Strategy for the Wealthy Family, author Mark Haynes Daniell says:

“In an attempt to repackage their in-house products in a more “custom tailored” fashion, and in part to justify larger management fees, many brokers and bankers send out youg and inexperienced staff members to develop an asset allocation model for their customers.” p 246

If you have a moderate degree of wealth – enough say to qualify to be a Vanguard Flagship client, you may be advised by one of Vanguard’s representatives on what your asset allocation should be. They are pretty upfront with the fact that their representative is going to compose your allocation using all Vanguard funds!

You might be tempted to use what Daniell calls “cookie cutter portfolios” which are really very basic variations of high risk, moderate and low risk allocations.

Any financial adviser is probably going to go on the safe side in his or her advice to you. They don’t want to be responsible for losing your money, they don’t want to be sued. Consequently they are going to recommend a more conservative approach.

So how do you build your own asset allocation model?

Everyone has their own method. Here is what I did.

Step one: List long and short term goals.

Step two: Make sure you have enough cash and cash equivalents to handle your short term goals and your ongoing living expenses plus any emergency expenditures.  You don’t want to have to cash out of stocks or bonds in an economic downturn just to meet short term goals and living expenses.

Step three: Think about how much risk you and your partner(s) can handle. Will you be tempted to sell in a downturn if you have too much invested in a certain way? Will you be able to sleep at night if things go haywire? and etc.  If you can’t sleep at night, it won’t pay to take on a lot of risk.

Step four: Determine the length of time until your long term goals become reality.

Are you saving for retirement, kid’s college, a down payment on a house, etc. When will those things happen? How many years are left to meet the goals?  You want to plan to have those assets in liquid form at the time those things will happen.

Step five: Become familiar with various types of assets – beyond the basic stocks, bonds and cash. You might be in a position to invest in real estate or REITs. You might be comfortable keeping part of your stash in collectibles (like artwork or antique cars) or in gold or silver. Perhpas you want to get into private equity or personal lending (as in the Lending Tree site).

Step six: Learn about ways to diversify. Even within a specific asset class, such as stocks, you can allocate different amounts to different geographic regions, different industries, different size companies and etc. The same holds true with bonds and cash.

Step seven: Look at what you already have and decide what asset type and what diversification type within asset class those are.

Step eight: Write down the asset classes in which you want to invest. For example, you might have a list that looks like the below:

• Real Estate – rental property
• Real Estate – REIT
• Real Estate – personal home
• Real Estate – undeveloped land
• Stocks – International emerging
• Stocks – Global large cap
• Stocks – Domestic pharmaceutical
• Stocks – Domestic energy
• Stocks – Domestic commodity
• Bonds – Long term tax free muni’s
• Bonds – Corporate high yield
• Cash – emergency currency and coin
• Cash – Bank accounts for savings
• Cash – T-Bills or CDs
• Cash – gold and/or silver coins
• and etc

Step nine: Based on all of the above, denote percentages for each asset class and each diversification area within class.

Step ten: Figure out where current assets fit, how much money you need to put into each class and start putting assets into each asset allocation category you built.

Step eleven: Review at least annually and revise/reallocate as needed.

Do you have a method to figure out your own custom asset allocation?  If so, what do you do?