Imagine someone asked you to decide right now how you want to divide your time between family, friends, work, and play for the rest of your life.
What would your answer be? What do you think is the optimal balance given your personal goals, values, and situation?
If you’re thinking to yourself something along the lines of “I have no freaking clue!”, join the club.
It’s almost an impossible question to answer. There are so many variables, so many unknowns, and even your best guess most likely feels like a shot in the dark.
For most people, trying to figure out the right asset allocation for their investments feels exactly the same way. You know it’s important, but you don’t really have a good way of figuring out what it should be.
The truth is that there IS no right answer, especially if you’re new to investing and making this decision for the first time. Asset allocation is part science and part personal preference, and you can only truly get a handle on the personal preference part through experience.
But you can absolutely get on the right track and this article will help you do that.
You’ll learn how to get a specific target asset allocation, as well as some factors that may lead you to make adjustments based on your personal values and goals.
Let’s get to it!
Quick refresher: What is asset allocation?
Your asset allocation is the way you spread your money out over different types of investments.
There are a number of different decisions that can go into it, but by far the biggest is how much of your money you put into stocks vs. how much you put into bonds:
- More money in stocks means a higher potential return, but also more risk that you won’t actually get that return and bigger swings along the way.
- More money in bonds means more certainty about your returns and smaller periodic drops in value, but also a lower potential return.
Investing is a constant trade-off between risk and return, and your asset allocation is the most powerful tool you have for managing that trade-off.
You can read more about what it is and why it matters here.
How to set your target asset allocation
There’s no surefire way to determine the exact right asset allocation for you. It’s a decision that’s part science and part emotion.
But there are some ways to get in the ballpark and that’s exactly what I’m going to share with you here.
Here’s essentially the same questionnaire I use with my clients to get an initial sense of their investment profile:
Click the link, answer the questions, and you’ll get a target asset allocation based on your responses.
Now, keep in mind that the answer you get here is NOT a specific recommendation. There are many factors that go into this decision, including your specific goals, values, and circumstances, and no questionnaire can factor all of that in.
But it’s a good start that gets you in the ballpark, and from there it’s a matter of making adjustments based on your personal situation.
So now let’s talk about why you might make adjustments.
Quick note: I adapted this from Vanguard’s Investor Questionnaire, which they have published and made available for use by both financial planners and individuals.
Potential reasons to invest more aggressively
What are some situations in which you should increase your allocation to stocks, exposing yourself to more risk in search of higher returns?
To be quite honest, unless you’re an experienced investor there aren’t many cases where I would recommend doing that.
Most people don’t really have a good sense of their personal risk tolerance until they’ve lived through a big market crash, and in the meantime sticking to a more conservative portfolio is more likely to lead to better behavior.
Still, here are a few situations in which you could at least consider investing more aggressively.
1. You’ve been through a market crash and it didn’t scare you
If you’ve already lived through a big market crash like the one in 2008, didn’t sell out of your investments at the time, and actually kept contributing all the way through it, you’ve proven that you can handle that kind of downswing.
If doing that was difficult, it’s probably good evidence that your asset allocation at the time was exactly what it should be. Sticking with it was hard, but you made it through.
If doing so was easy, and if you weren’t scared or concerned as the market continued to fall, then maybe you can handle an even larger allocation to stocks.
2. Your investment timeline is flexible
The benefit of the stock market is a higher expected return. The downside is that there’s huge variability in the returns you actually receive.
You can’t count on the stock market to help you hit a specific financial target on a specific date, because you just don’t know what it’s going to do during any given day, month, year, or even decade. That’s why using the stock market for short-term goals is generally a bad idea.
But if you have a lot of flexibility with your goal, and if you could delay it for a potentially significant amount of time without stress or hardship, then you may be able to take on some extra risk with the hope of getting higher returns and reaching your goal even sooner.
3. You’re saving more than you need to be
If your savings rate is significantly higher than what it needs to be, you could consider investing more aggressively for the potential of a double bonus.
If it works out and you get higher returns, that will compound with your savings rate to get you to your goal even quicker.
If it doesn’t work out and you get lower returns, your savings rate will help to offset that loss and keep you on track.
Potential reasons to invest more conservatively
On the flip side, there are a number of reasons to consider investing less aggressively and put more of your money into bonds than what the questionnaire suggests.
Here are a few.
1. You don’t need higher returns
A few months ago I shared a simple spreadsheet that helps you figure out the rate of return you need given your savings goal, your current savings, and your monthly contribution. Here it is: Savings Calculator.
If you run the numbers yourself and find that you can reach your goal with lower returns, why take the risk of NOT reaching it by stretching for higher returns?
Investing more conservatively will not only increase your odds of hitting your goal on time, but it will make for an easier ride along the way.
The trade-off will be the lost potential to end up with even more money, but as the saying goes: “pigs get fat, hogs get slaughtered.”
2. You haven’t experienced a market crash
If you haven’t lived through a big market crash, the truth is that you don’t know what it feels like to watch your account balance drop and drop and drop with seemingly no end in sight.
It’s a scary thing to live through and even the most experienced investors have trouble sticking to their plan when things get bad.
Until you’ve been there you don’t know how you’ll react, and there’s also a decent chance that you overstated your risk tolerance when completing the questionnaire, leading to a more aggressive recommendation than what you can truly handle.
I’m a big fan of Rick Ferri’s Flight Path approach to asset allocation because it factors in this very thing. It encourages investors to start out relatively conservatively and get more aggressive as you gain experience, IF that experience suggests that you can handle being more aggressive.
Remember that when you first start out your savings rate is far more important than your investment return. So you’re not missing much if you invest more conservatively at the start, and the potential bonus is that the next market crash doesn’t scare you off from investing altogether.
3. Investing makes you nervous
If you know you’re supposed to be investing but you’re scared about the possibility of losing money, it’s okay to be more conservative than the “norm”.
Like I just said, your savings rate is far more important as you start out anyways, so start making those contributions, dip your toes into investing with a conservative plan, and if needed make adjustments as you gain experience.
4. Your investment timeline is not flexible
If you’re dead set on reaching your goal at a specific point in time, and especially if that time is in the near future, the stock market carries some significant risks.
In general, I’m not a big fan of using the stock market for any goal that’s less than 3 years away. I’d rather put my money in a savings account and know it will be there when I want it.
And even for longer-term goals, say 3-10 years out, I’ll generally be pretty conservative unless I’m willing to be flexible about when I’m able to reach that goal.
If you have a strict timeline, just know that a higher allocation to stocks introduces more uncertainty about hitting that timeline.
When to re-evaluate your asset allocation
In most cases, your investment plan should largely be set-it-and-forget-it. Other than occasional rebalancing, your job is to keep contributing and let your investments do their thing through the ups and downs.
But it is worth re-evaluating your asset allocation from time to time, especially when something significant has changed in your life or when your financial goals have changed. In those cases your need and/or ability to handle risk may change as well, meaning that a new strategy might be a good idea.
Here are a few examples of situations where it’s worth re-evaluating your asset allocation:
- Marriage or divorce
- Receiving an inheritance
- Significant change in retirement goals
- You just lived through a big market crash AND the subsequent recovery (perfect time to reflect on your true risk tolerance, once things are calm again)
- A big, unexpected financial commitment, such as caring for aging parents
Make your best educated guess and get started
Even with the help of a questionnaire, deciding on your asset allocation can be intimidating. It feels important and there are a lot of unknowns, which may make you hesitant to pull the trigger.
So know this: there is no perfect answer but there are plenty of “good enough” answers. If you follow the steps laid out here, you will almost certainly end up in the “good enough” camp with plenty of time over the rest of your investment life to make adjustments as needed.
So make a decision, put it in place, and get back to making those contributions.
And with that, what’s your target asset allocation and what went into your decision? Let’s talk about it in the comments below.