When we meet with a new client, one of our tasks is to determine an appropriate asset allocation for the funds they invest. At a very basic level, the question we are trying to answer is “what percentage of the investment portfolio will be comprised of equities (stocks), and what percentage will be fixed-income (bonds)?”
In general terms, over any given time period, one would expect equities to have greater potential for gains and losses than bonds. Bonds are not always the least volatile asset class, but as compared to equities, they are typically less volatile. There are always exceptions, but usually, a more aggressive investor will have a higher concentration of equities over bonds than a less aggressive investor. When we gather information to answer the allocation question, one significant factor to consider among others is the length of time between now and when the investor needs to access the funds.
Other factors to be considered include outside assets/liabilities, pensions/annuities/Social Security, tax-qualification of accounts, job stability, emergency funds, family inheritance goals, etc.; however, proximity to needing the funds is one of our more significant components.
At the end of any given 10- 20- 30-year period, we can be relatively confident that equity markets will be higher than they were at the start. Over shorter periods of time, that confidence dwindles. As I write this, I am comfortable making the prediction that the U.S. equity markets will more likely than not close higher on 12/31/2050 than on 12/31/2022. However, I cannot predict with reasonable certainty where the markets will close at the end of tomorrow.
Therefore, an investor who has more time before needing to access the funds also has more time to recover from market drops, which means the investor’s funds can be more heavily allocated to equities. The flip side of that coin is that an investor who has less time before needing to access the funds typically may want to be more heavily allocated to bonds or other lower volatility assets.
An important note is that asset allocation should be tailored to each client’s specific goals. A retirement goal is usually closely tied to an investor’s age, but that is not the case for all goals. For example, an investor’s retirement funds may have a different allocation than funds saved for their children’s college education. An investor may be 20-30-years away from retirement, so the portion of their funds saved for their retirement goal is allocated more heavily toward equities. The same investor has a 16-year-old child who is just a couple of years out from starting college, so the portion of the funds saved for the college tuition goal is allocated more heavily towards lower volatility asset classes.
Simply knowing the investor’s time horizon for each goal is not enough. As we can say with many things in life, “it just isn’t that simple.” Everyone has their own goals and each investor is different, so this is not a one-size-fits-all operation. In addition to the multitude of other factors touched on above, this is a time where another of the gray areas of financial planning comes into the equation: emotions.
One question we ask our clients is “How prepared are you emotionally to withstand sharp drops in the value of your portfolio?” If the client starts sweating and shaking, then no matter the number of decades to meet the goal, it does not make sense to choose an allocation comprised almost entirely of equities. We do our best to keep our clients from making investment decisions based on emotions. Emotional investment decisions can lead to piling on at the top and selling at the bottom. However, we understand that because we are all humans, we all have emotions. Therefore, our best hope is to address likely negative emotions before they happen in an attempt to mitigate the potentially negative outcomes of those emotionally-driven decisions.
It is also not at all uncommon for spouses to have vastly different emotional capacities for potential gains and losses. We have seen the example of a couple in our office, married for 40+ years, realize for the first time that while one spouse was very comfortable with taking more risk for potential market gains, the other spouse was so uncomfortable with the idea of potential large losses that they were almost losing sleep over it.
These are important conversations to have to make sure everyone is on the same page. It is important to structure allocations on an account-by-account basis based on specific goals, and on a global household level to ensure that each investor is aware of, and comfortable with, the potential risks and outcomes of such an allocation.
As prudent advisors, we cannot guarantee any kind of market performance. No one can because no one honestly knows for certain what will happen in the future. In fact, just about the only guarantee we can make about the markets is that they will go up and they will go down, some years more than others. By addressing the potential emotions an investor might feel during a sharp decline before it happens, we can avoid at least some of the reckless decisions that may have been made when that time does come.
Read more about Asset Allocation here. Watch videos from our advisors here.
Ballast, Inc. is a registered investment adviser with the SEC. Registration with the SEC does not indicate that the adviser has achieved a particular level of skill or ability, nor is it an endorsement by the SEC. All investment strategies have the potential for profit and loss. Ballast, Inc. is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation.
