FREE NEWSLETTER

An Antacid Problem

Adam M. Grossman

THERE’S AN IRONY IN the world of personal finance: The activity that’s the most entertaining—picking stocks—is also, according to the data, one of the most counterproductive. Meanwhile, making asset allocation decisions is more akin to watching paint dry, and yet—according to the data—that’s one of the most important decisions an investor can make.

Asset allocation refers to the split among your investments—how much you hold in stocks, for example, versus bonds or real estate. According to a well-known study by Gary Brinson and colleagues, asset allocation drives about 90% of a portfolio’s results. In other words, for all of the time people spend debating which stocks or mutual funds to own, the reality is that those decisions are responsible for just a minority of an investor’s results. By contrast, the vast majority of investment results—and thus, the most important decision—hinges on a single question: How is a portfolio allocated?

In the past, I’ve outlined the process I recommend for choosing an asset allocation. Investors should ask themselves three questions:

  • How much risk do I need to take? This helps determine the minimum amount that should be invested in stocks.
  • How much risk can I afford to take? This indicates the maximum that should be held in stocks.
  • How much risk can I tolerate from an emotional perspective?

For many people, the answers to these questions result in a fairly narrow range of advisable allocations. To ensure growth, they can’t afford to hold too little in stocks. Meanwhile, to manage risk, they can’t afford to hold too much.

But for other investors, there’s a much wider range of possibilities. At the extreme, consider someone like Warren Buffett. A while back, Buffett revealed the allocation he’d chosen for his family trust: 90% in stocks and 10% in bonds.

The reality, however, is that because of the scale of his assets, he could have instead put 90% into bonds and just 10% into stocks, or chosen virtually any other combination. While none of us has Warren Buffett’s wealth, this same dynamic begins to apply as one’s portfolio gets larger. Asset allocation, in other words, becomes less about math and almost entirely a matter of personal choice.

If you’re in that position, it’s a luxury in some ways, but it also presents a challenge: In deciding on an asset allocation, it means there’s no easy answer. In fact, in contending with this question, investors often cite two opposing—but both entirely reasonable—philosophies.

On the one hand, some reference author William Bernstein, who has famously said, “When you’ve won the game, stop playing with money you really need.” The implication: We shouldn’t take more risk than is necessary. On the other hand, more risk-tolerant investors will often say, “If I can afford to take more risk, why wouldn’t I? Why leave money on the table?” If this is a question you’re wrestling with, here are six approaches I’ve found most helpful.

Employ multiple lenses. If you’re trying to choose between an allocation of, say, 40% stocks or 60%, try converting those percentages into dollar terms. For each of the allocations you’re considering, look at the number of dollars you’d have in stocks and ask how you’d feel if the market declined by half, as it did in 2000-02 and in 2007-09. Next, consider the dollars you’d have in bonds and ask how long that might carry you if the stock market saw another big decline. Always look at the decision from more than one angle.

Recognize that there are many “right” answers. In fact, there are often more right answers than truly wrong answers. Continuing with the above example, if you’re torn between an allocation to stocks of 40% or 60%, recognize that either decision is more reasonable than going all the way to an extreme of either 0% or 100% stocks. In other words, don’t worry too much about getting to an answer that’s precisely right. Instead, simply try to get to a decision that, above all, feels reasonable.

Avoid formula-driven answers. When it comes to asset allocation, there’s a variety of rules of thumb. For example, there’s the dictum that an investor’s allocation to stocks should equal 100 minus his or her age. Others look to Modern Portfolio Theory to structure their investments.

While each of these might contribute to the mosaic, there’s no formula that can capture the full picture. That’s especially true because all formulas are built on assumptions about the future. Without the benefit of a crystal ball, it would be impossible for anyone to know the absolute optimal allocation.

Just as investment markets are unpredictable, so too are our own needs and goals. Consider my college roommate. Some years ago, he and his wife were expecting their first child. But they were surprised when the doctor told them they should get ready not for one baby, but three. Life can throw curveballs. Sometimes, our preferences simply change over time. That’s a reason to leave a little latitude in whatever allocation you choose.

Just as our needs aren’t static, our mindset can change as well. Suppose you’re in your 50s or 60s and thinking about retirement. During your working career, you’ve seen more than one market downturn, so you know what it’s like to experience a reversal in your portfolio.

The challenge: If you haven’t retired yet, then—by definition—you don’t know what it’s like to live through a downturn while in retirement. Retirees often report that downturns are a very different experience because they’re drawing on their portfolios rather than contributing new savings. One solution: You might choose to be a bit more conservative with your investments than you’ve been in the past.

In the end, it’s important to realize that asset allocation is only partly a math problem. More than anything, it’s what I call an antacid problem. In settling on an answer, the question you really want to ask yourself is, “What can I live with?” That, I think, will get you closer to the right answer than trying to divine what’s precisely, mathematically optimal.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our twice-weekly newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
9 Comments
Newest
Oldest Most Voted
Inline Feedbacks
View all comments

Free Newsletter

SHARE