First off, I’m 34. So I’m going to trick myself into believing I’m not in my mid 30s until next year. But I figured it was appropriate to write a follow-up to my last post about when should one invest in the stock market. The answer is generally now compared to sitting on excess cash. While much of that article focused on stocks, the main point was to put money to work in line with your long-term asset allocation.
As such, it makes sense to dig a little deeper and discuss what constitutes an appropriate allocation. Every situation is unique, but given the average Personal Capital dashboard user is in their mid-30s, I thought we could review a very simple scenario: me.
My Asset Allocation
I invest in roughly 85% stocks, with the remaining 15% made up of alternatives and small amount of bonds. Why? The simple answer is that I have a long time horizon and highly aggressive risk tolerance. I also don’t have any major upcoming expenses, like a home down payment. So I can afford to take on a substantial amount of risk. Even if the market takes a nose dive, I’ll have plenty of time to recover my losses.
If all of the different asset allocations fell on a spectrum, I would fall to the far right (in the aggressive camp). Not everyone in my age group would be in the same spot, but they’d likely be close. After all, most of us share the same primary goal: growing our money as much as possible for retirement. Where we could differ is risk tolerance. So if someone was aggressive but couldn’t stomach full market exposure, it would make sense to reduce their overall equity weight and add some fixed income.
Even if someone in their mid-30s classified themselves as conservative, they would still likely need majority of their assets invested in equities. Stocks have historically offered the highest returns (~8% per annum), and that growth is often necessary to meet retirement goals. The exception (for someone purely saving for retirement) is when that person has already amassed a sizable investment portfolio worth many times their annual spending. In this situation, they may require less growth, allowing them to be less dependent on equities. The name of the game is capital preservation.
However, being in this situation at the age of 34 is much more the exception than the rule. The truth is that most individuals in my age group are financially similar in that we need growth to help us reach a more comfortable retirement. Some might have additional goals like saving for a child’s education, or buying a home next year, but taken as a whole most young investors do not have tremendously complex financial lives. And for the most part, their portfolios should be more heavily weighted in equities to boost long-term growth potential.
Given my financial situation and the fact that I’m highly aggressive, some of you might ask why wouldn’t I simply be 100% invested in stocks? After all, stocks have historically performed best out of the major asset classes. While true, it doesn’t mean I should put all my eggs in one basket. Just most of my eggs. The idea is to establish a portfolio of lowly or uncorrelated asset classes. In other words, some assets should zig while others zag.
This is a commonly misunderstood area of investing. Even though adding exposure to alternatives and fixed income slightly reduces my portfolio’s return potential, it also significantly reduces risk. Said another way, these asset classes behave differently than stocks. So when the market takes a dive they might fall less, stay flat, or even go up relative to stocks. This reduces overall volatility, and over time can potentially even result in higher aggregate portfolio returns than 100% stocks.
Establishing the percentage of stocks, bonds, and alternatives is just the first step. It’s critical to diversify even further. Within equities, I’m diversified across domestic and foreign stocks, including emerging markets. Within fixed income, I have exposure to government bonds, inflation-protected bonds, and foreign bonds. And my alternatives are made up of REITs, commodities, and gold. The idea is to spread out risk as much as possible, while still keeping my portfolio’s return potential in line with my investment goals.
Of course, if the primary goal is not retirement, or you’re simply at a different stage in life, you may require an entirely different asset allocation. For more in depth information, please read our very thorough post on Successful Asset Allocation.
Hope this adds some color!