Developing an Asset Allocation Model (Part I)

In my May 24, 2010 post I discussed rebalancing portfolios and how that assists in buying low and selling high. This week I rebalanced because stocks have been going up and bonds declined in value, so my portfolio was off kilter.

In addition to rebalancing this week, I also changed the target percentages for various asset classes. The percentage allocation to asset classes should be at the core of any investment program. One size does not fit all. I knew someone who got an A on an MBA finance exam when she answered a question about asset allocation by indicating she was completely risk averse. Preservation of principal was her only objective and therefore she would keep all of her money in cash, short-term treasuries and government insured bank accounts and money markets.

As long as the US government does not default, this investor will meet her objective of capital preservation. Since I don’t have sufficient assets to live off the current paltry interest return treasury bills, money market funds and the like pay, I need to take more risk in order to (hopefully) get greater return. My risk tolerance and yours may not be the same. We may have different objectives (mine is to not run out of money before I die) for our investments. If you are not sure of your objectives and risk tolerance, you can use any of a number of online tools to help define them. Use several since they have different implicit assumptions and their average advice may be more accurate than any one model.

I’ve periodically tweaked my asset allocation as I moved from employed to retired. Contrary to many popular wives tales, asset allocation need not change on account of age per se. The critical components are (1) whether you are accumulating, spending or in transition between the two, and (2) when you need to spend the money. Bull markets are never a problem; what happens to your assets in the inevitable down market cycles and how that affects your plans is the key issue.

When you are accumulating wealth, bear markets can be good things. You are a buyer regardless of market conditions. If you have $1,000 to invest, you will get twice as many shares if XYZ sells for $10 a share than you do when XYZ sells for $20 a share. If you have many years of accumulating to go, your future investments likely far outweigh the value of your current portfolio, and so market ups and downs are of little concern.

In the spending phase, you no longer have “excess” income to invest. Your portfolio accumulation is finished and you no longer benefit from buying at depressed levels after a market “correction.” Judicious rebalancing will help, but, for the most part, the only way to adjust to decreased investments is to decrease spending or dying earlier. Neither are pleasant alternatives. While a portfolio of Treasury bills will solve the problem of investment losses, they provide little real return, which leads us back to the problem of insufficient funds to live solely on Treasury bill income. Most of us must take some risk in our portfolio.

I define the transition phase as the period before retirement in which the size of accumulated investments has become large enough that future annual additions can no longer make up for large market declines. The earlier you start to save, the quicker the transition period comes.

Next up: Asset Classes to Consider in Your Portfolio

~ Jim