Optimal Asset Allocation: How To Build A Strong Portfolio Using Four Basic Strategies
If only you had the perfect portfolio one that grew 12% a year like clockwork – without a losing year – then you’d be set for life.
But just what is the optimal asset allocation for you? And what’s the easiest way to get there from where you are now?
For starters, when you’re young, you need growth. You can afford to take risks, because even if you completely blow it, you’ve still got years to make up that money you lose. And when you’re older, you don’t want to have to go back to work. So you’ve got to be much safer with your investments.
A Simple Asset Allocation Rule That Could Save You Money
The simplest rule of thumb I use to account for these different investment needs is this:
100 minus your age is the percentage you should have in stocks. (Particularly in a “set it and forget it” portfolio.)
So if you’re 30, you should have 70% of your investable funds in stocks. And if you’re 70, you should have 30% in stocks. This is because stocks are less safe than the alternatives, so the older you get, the less you should have in them.
This rule of thumb is very rough, I know, but it’s not just pulled out of the sky. It comes from studying nearly 80 years of stock market returns. Now let’s take it to the next level here. And using all this homework I’ve done, let’s get closer to the perfect asset allocation model for you.
What History Tells Us About Achieving Optimal Asset Allocation
Take a look at how the three particular portfolios listed below have performed over the last 76 years. While you look at them, consider which one is most appropriate for you. Consider things like, “Is it worth it to take more risks to improve my investment returns from a ‘safe’ 7% a year to a ‘risky’ 10%?” This does make a big difference over the long run. But I can’t answer that question for you.
You are the only one who knows what level of risk lets you sleep at night. All I can do is arm you with the facts, to know whether you should choose a safe or a risky portfolio. Here are the facts, as history tells us:
- SAFE PORTFOLIO — 20% stocks, 80% bonds. Throughout history, this portfolio has averaged 7.0% a year. Its WORST year was a loss of 10.1%. It lost money 17% of the years.
- BALANCED PORTFOLIO — 50% stocks, 50% bonds. Throughout history, this portfolio has averaged 8.7% a year. Its WORST year was a loss of 22.5%. It lost money 22% of the years.
- RISKY PORTFOLIO — 80% stocks, 20% bonds. Throughout history, this portfolio has averaged 10.0% a year. Its WORST year was a loss of 34.9%. It lost money 28% of the years.
So what’s appropriate for you? To find out, you’ve got to answer tough questions, like, “Can I handle a 35% loss in a year if I held the risky portfolio?” or “Do I really need to risk it all, when the difference between being safe and being risky is only 3%?”
Let’s keep digging, to get you even closer to what’s appropriate for you…
An Optimal Asset Allocation Model
In talking with C.A. Green, he outlined using a portfolio of about 60% stocks as a good moderate choice, based on history. That type of portfolio has returns nearly as nice as the “risky” portfolio, having returned 9.1% annually (on the average) throughout nearly 80 years of history. But it doesn’t have quite as much risk, because 40% of the recommended asset allocation is outside the stock market.
Along these lines, I talked with a longtime friend and financial consultant this week to get his input, and he had a great suggestion.
He reminded me that, to really get the most return for the least risk, you must diversify within each investment class. For example, he told me that a lot of his clients came to him with what they thought was a diversified portfolio of stocks and bonds.
But the reality is that those people weren’t properly diversified; they only held tech stocks, instead of stocks from all sectors.
C.A. Green talks about this regularly. His general recommendation for investment allocation is:
- 30% U.S. Stocks
- 30% Foreign Stocks
- 10% High-quality Corporate Bonds
- 10% High-yield Bonds
- 10% U.S. Treasury bonds (TIPS)
- 5% Real estate stocks
- 5% Gold and precious metals
This is really starting to get specific now! But that’s okay. You’re now armed with a lot of information, which can help you better decide what path to take to allow you to sleep at night. You’ll of course need to tweak this a little based on your age and risk tolerance.
However, I also like to use my knowledge to make adjustments to my perfect portfolio based on market conditions. For example, as you know, I think the stock market is extremely expensive right now. So I’m recommending that my readers lower their exposure to the stock market, as I think stock market returns will not be very good in the coming years.
Never Forget Asset Allocation’s Tactical Basics
The more you read about this topic of asset allocation, the more confusing it often gets. Different “scientific” studies on this topic give strikingly different results. (In fact, many studies based on only the last 10 years of data said you should be 100% in stocks but you would have been clobbered in recent years on that advice.) So while I of course recommend doing all the homework on optimal asset allocation you can, keep in mind the basic strategies I’ve laid out here:
- The “100 minus your age rule” is a great starting point for how much you should have in stocks.
- As you do more homework and see different strategic allocations, don’t forget the numbers I presented to you they’re based on 80 years of data and include the 1929 crash, so they are a true representation of what to expect.
- The 60/40 mix as recommended C.A. Green is a good mix of risk and return for many – “set it and forget it” portfolios.
- As both C.A. Green and my longtime friend recommend, for best results you’ve got to diversify among different types of stocks and bonds as well as among asset classes.
It bears repeating, the truth is that there is no one perfect asset allocation model. It’s different for everyone based on age and risk tolerance. However, if you stick with these four basic suggestions, you should be more than capable of finding the most optimal asset allocation for you.