Factors Affecting Asset Allocation

Asset allocation can be the driver of investment returns as well as the primary risk management component in an investment portfolio. Its importance, therefore, cannot be overstated.

The factors affecting asset allocation are investor age, net worth, liquid assets, emergency fund, time frame, financial goals, risk tolerance, alternative investments, and investment correlation.

As you will see, choosing the right asset allocation is a fine balance among various factors that affect asset allocation. While there are rules of thumb and many suggested asset allocation models, every investor’s overall financial situation must be considered as you will see below.

Investor Age

Stocks have more volatility than bonds. Hence, stocks are considered riskier than bonds.

In general, the younger an investor is, the more portfolio risk is acceptable, while older investors should have less risk in their portfolios.

This is because younger investors have a longer time frame to recover from the occasional stock bear market and older investors are usually near or in retirement making it harder for them to recover financially from a stock bear market.

Many older investors question if stocks are safe for retirement but a focus on asset allocation reduces risk through diversification.

The very broad rule of thumb for asset allocation is that investors should invest 100 less their age in stocks. A 60 year old, then, would invest only 40% of their portfolio in stocks and invest the remaining 60% in bonds or other defensive investments.

This rule has been tweaked in recent years due to the poor return bonds have had and are expected to have because of low interest rates, however. Additionally, many older investors are playing catch up with retirement savings, so they are investing higher than usual allocations in stocks vs bonds.

Net Worth

Net worth should be considered in choosing an asset allocation.

In general, a 60 year old with a net worth of $3,000,000 can tolerate a higher stock allocation than a 30 year old with a net worth of $ 25,000, for example.

Liquid Assets

In the example above, a quick net worth calculation reveals the wealthy individual above has most of her net worth tied up in her home with a market value of $2,700,000, a nonliquid asset that costs money every month to maintain.

While it may seem her net worth is enough to retire, her investment capital is low at only $300,000; she has a very low amount of liquid assets given her age and home value. As much as she needs the growth that comes from stocks, she is older, and she has little in liquid assets, so she may not want the risk from a high allocation in stocks.  Of course, as soon as she sells her home, most of the factors affecting her net worth decision will completely change since she will no longer have too much net worth in her home.

On the other hand, let’s say the 30 year old with a net worth of $25,000 rents rather than owning a home, makes more than she spends, and has job security plus a backup side hustle with good future income potential.

In this case, an asset allocation with a higher percentage in stocks would likely be more appropriate for the 30 year old even though her net worth is a fraction of the $3,000,000 net worth investor.

Emergency Fund

Closely related to liquid assets is the amount in an emergency fund as an asset allocation factor.

For example, an investor without an emergency fund will likely want at least some of his portfolio in bonds or short term debt since he may need cash to pay bills if met with an expected job loss or other financial discord.

On the other hand, an investor with $100,000 in an emergency fund can invest more confidently in more volatile assets, such as stocks, since she has plenty of funds to cover most potential financial emergencies.

Time Frame

Intertwined with all the factors affecting asset allocation is the time frame for which the investment money will be needed.

A 40 year old couple committed to pay for college starting in one year for their twins will likely want the money they have invested in a college fund to have a lower allocation in stocks. They know they will need to be able to find college soon with their investment savings.

A 50 year old investor planning to retire next year who isn’t clear she has enough retirement savings will likely want a lower allocation to stocks since her investment time frame is close and stocks are more volatile while a 50 year old with ample savings and planning to never retire may want less in bonds.

Time frame relates to age, but it is also a stand alone factor when it comes to asset allocation. As you can see, the factors affecting asset allocation are a function of the reason for the investment fund.

Investment accounts are created for different purposes, be it college, buying a home, retirement, leaving a legacy, or other reasons. While some investors approach asset allocation holistically, each of these account purposes will have different factors affecting the best asset allocation for a standalone account.

Financial Goals

Stocks have had higher returns than bonds and most other asset classes over a long period of time. For this reason, investors who need to earn a higher return to reach their financial goals usually invest as much as they can in stocks.

Financial goals for a 50 year old will be very different from financial goals for a 30 year old but both should be built around an overall wealth plan that defines an end goal for retirement savings.

Oftentimes, however, needed returns take a back seat to the fact that stocks are more volatile than bonds for investors who are extremely risk intolerant.

Risk Tolerance

Risk tolerance may be the single largest factor to consider when selecting an asset allocation model even though age and desired return are high priorities, too.

Someone with a very low risk tolerance will likely want a lower stock asset allocation than someone with a high risk tolerance and vice versa.

It is, however, important to dig deeper into risk tolerance to determine if the level of risk tolerance is logical.

For example, an investor whose parents lost all their money in the stock market might have a low risk tolerance that is tied to investor emotions rather than logic.

On the other hand, an inexperienced young investor who invested in high growth stocks and hit the early stages of a bull market and economic expansion just right may have a high risk tolerance due to misperceptions about his investing ability or about stock market risk, in general.

Many investors have a high risk tolerance until they experience a secular bear market. Then they develop a low risk tolerance just when stocks are selling at low valuations again. This common paradigm is discussed in my investor emotions video below.

Risk tolerance is very important in determining asset allocation. It is, however, important to consider the logic behind risk tolerance. A financial coach can help with this.

Alternative Investments

Most investing information is geared toward stock and bond portfolios. Consider, however, an investor with a real estate rental portfolio.

The rental properties could certainly be considered as an asset that would reduce if not replace entirely bonds in a portfolio given their stability and income generating factors.

In other words, it makes sense to think of asset allocation among both traditional investments as well as alternative investments from a return, risk management, goal achievement, and income perspective.

Asset Correlation

Expanding on the inclusion of alternative investments as a factor in asset allocation, the movement correlation of assets owned should also be considered.

The non-correlated movement of stocks and bonds is at the core of most asset allocation models. Alternative investments held outside a liquid core portfolio should also be considered, however, from both a risk management perspective as well as an income perspective.

For example, an older investor who might otherwise allocate a lower amount to stocks to reduce volatility may not do so if he has a large portfolio of real estate rental properties. This is because rental properties tend to hold their values during bear markets and other financial discord due to the high and consistent income they can provide.

 

Asset Allocation Examples

Let’s look at two asset allocation examples below where the traditional asset allocation rules are challenged based on the investors’ overall financial situation. Asset allocation is more of an art than a science.

Too, there are both pros and cons of asset allocation even though it is sometimes viewed as the holy grail of investing.

Asset Allocation for a 35 Year Old

First, let’s consider a 35 year old couple who invest together, Beverly and Joe. This relatively young couple has 4 children.

Joe lost his job last month. There is a recession, making it hard for him to find employment with a salary comparable to what he made prior to being laid off.

Beverly has been working only part time since their third child was born making $3,000 a month which is helping but not covering cash flow.

Fortunately, Beverly and Joe have saved a nest egg of $100,000. Their monthly expenses are about $10,000 a month including taxes and home mortgage. They had moved to San Francisco for Joe’s work which is more expensive than their prior home in Tennessee.

Joe and Beverly have to withdraw $7,000 from their investment savings this month to pay their bills. Their asset allocation prior to Joe losing his job was 75% stocks and 25% bonds, which seemed appropriate given their age.

They are worried that their allocation to stocks is too high, particularly since the stock market is the highest it has ever been, even though they prefer more passive strategic vs tactical investing.

Joe and Beverly decide to change their asset allocation to 50% stocks, 30% bonds, and 20% money market account at least until Joe is employed again so they have access to money to pay the bills for almost three months without having to sell investments. Plus, the bonds will help manage risk from the stock market. and help them be prepared for a bear market should one occur during this already vulnerable time.

Asset Allocation for 50 Year Old

Bill and Susan are 50 years old with 1.5 million dollars in retirement savings. They both plan to retire at 55 in 5 years and make retirement withdrawals of 4% a year adjusted for inflation from Susan’s retirement account when needed.

Their cost of living is $8,000 a month. Their three rental properties are paid in full and generate income of $4,000 a month net.

Given that Bill and Susan have rental income, will be withdrawing $5,000 from their retirement accounts and will get social security in their 60’s, they have decided to use an asset allocation of 75% stocks and 25% bonds even though they plan to retire in 5 years and are 55 year old.

Another reason they want to keep their high allocation to stocks is because they plan to shift from growth to income stocks when they retire so investment income from dividends will cover about 66% of their planned retirement withdrawals calculated as follows:

$1,500,000 retirement savings x .75 asset allocation to stocks = $1,125,000 x .035 yield = $39,375/12 Months = $3,281.15/$5,000 = .66

The large portion of retirement withdrawals covered by dividends will make them less dependent on stocks increasing in value every year they are making withdrawals in retirement. This strategy will also reduce risk in stocks since dividend stocks tend to be less volatile than growth stocks.

Summary for Asset Allocation Factors

As you can see from these examples, several factors override age when determining asset allocation for both a 35 year old couple and a 55 year old couple even though the typical asset allocation factors suggest a 35 year old couple would have more in stocks than a 55 year old couple.

Every investor must consider all the factors affecting asset allocation to make the best decision for them.