A major part of being a successful investor is having the right asset allocation model for your risk tolerance and investing for the long term. If you are reading this post, chances are you have the wrong asset allocation model.
How do I know this? Look at the questions below. If you answer yes to either of them, then you have the wrong asset allocation model.
- When the stock market crashes, you sell everything and run for the hills
- When an investment doesn’t perform as well as you hoped, you sell and buy something else
By allowing your emotions to get the best of you and to sell out of an investment based on fear or worry, you are taking on too much risk. You need to dial back the risk and choose an asset allocation model that fits you better.
How do you do this? Let’s take a look at 11 portfolios, all with a different asset allocation.
Looking At Asset Allocation Models
In the image below, you see we have 11 portfolios. On the far right, we start out with a 100% bond, 0% stock portfolio.
As you move to the left, the percent of bonds you hold decreases by 10% and the percent of stocks you hold increases by 10%. By the end, you have a portfolio made up of 0% bonds and 100% stocks.
Now look at the picture below. This picture has the one year and average annual return for each of these asset allocations. Let’s first focus on the average annual returns.
For a 100% bond portfolio, you can expect to average a 5.5% annual return on your investment. Since stocks tend to return more than bonds, as you move to the left, you see that the average annual return increases to 10% for a portfolio made up of 100% stocks.
Now let’s look at the one year best return for each portfolio. This is represented by the top number on the vertical bar. For example, for a 100% bond portfolio, the best one year return is 32.6%.
For a 60% stock, 40% bond portfolio, the best one year return is 36.7%. This is the number that tends to get investors into trouble. You focus on this one year potential and get excited about your money growing so fast.
What you don’t take into account is the number at the bottom of the vertical bar. This is the greatest one year loss for each portfolio. When looking at a 100% stock portfolio, this is a negative 43.1%.
How comfortable are you with the potential of losing close to half your money in one year? Before you say the chances of this happening are slim, look no further than 2008 or 2002.
The reality is large swings like this happen more than we realize. Let’s look at an example to see the impact this drop has on your money.
Let’s say you invest $10,000 in a 100% stock portfolio the beginning of the year of the worst decline. After this the market returns the average 10% return. Here is what this looks like.
After 7 years, your investment is finally back to what you originally invested in the market.
Unfortunately, you being the average investor never experience this. Here is the typical way the average investor reacts. You invest $10,000 at the start of the year and the market drops 43%.
Out of fear, you sell your holdings and put your remaining $5,690 into a bank account that at best pays you 1% annually. In 7 years, you are considering returning to the market. Your investment is now worth $6,039.
By allowing fear to control your decisions, you cost yourself over 40% or $4,000! What if things could be different? What if there was a way to choose an asset allocation model that limited your risk but still allowed you to earn a decent return?
There is. And it all starts with you getting honest with yourself and picking the right asset allocation model for your risk tolerance.
Let’s look at the exact same example, only this time, you choose an asset allocation model that fits your risk tolerance.
After looking back at the chart of the various portfolios, you agree that a 60% stock, 40% bond portfolio is the best option for you. You are comfortable with the potential loss of 26.6% of your money in a given year.
Now let’s say you invest $10,000 and this happens. You lose 26.6% that first year. You don’t panic and stay invested. Here is how your money grows in the following years with an average return of 8.7%.
By investing this way and staying invested, you earned your original investment back in 5 years and after 7 years you have a gain of more than $2,000!
Reasons Why You Pick The Wrong Asset Allocation Model
- You want to get rich quick
- You seek short term gratification
- You discount the chances of a market drop
- You think you are smarter than the market
If you look closely, all of the reasons above are tied to emotion. In all cases, you are greedy. You want as much money in as little time as possible.
But when you invest this way, you set yourself up for disappointment and failure.
The end result is never growing your money and thinking that the stock market is rigged against you. As a result, you decide to not invest at all.
The Danger Of Not Investing At All
I briefly touched on the idea of not investing at all above, but want to take a minute to show you the full impact of avoiding the stock market altogether.
Let’s say you invest $3,000 a year into a portfolio that is made up of 60% stocks, 40% bonds, earning an average annual return of 8.7%. You do this for 30 years.
At the end of the 30 years, you end up with over $420,000. But what if you avoided the stock market altogether and just put the money into a bank savings account?
Let’s say you averaged at best 2% annually for the 30 years. How much do you end up with?
By putting your money into a bank savings account, you end up with just over $124,000.
That is a difference of $296,000!
Think about this in terms of your retirement. If you spend $40,000 a year, the money you invested and grew to $420,000 will provide you with close to 11 years of income. This isn’t taking into account continual growth of the money while retired.
How many years can you live off the money you kept in a savings account? About 3 years.
If you don’t invest your money in the stock market, you are going to need to save a lot more money just to afford retirement.
How To Get Over Your Fears Investing In The Stock Market
So how do you get over your fear of investing in the stock market or jumping in and out when the market gets volatile?
Here are some steps:
- Get your asset allocation model correct. When you invest based on your risk tolerance, you are less likely to jump in and out of the stock market.
- Create an investment plan. Having an investment plan is critical to your long term success. When you feel the urge to act, you can read through your plan and remember why you are investing.
- Tune out the noise. Stop watching the news and reading stories when the stock market gets volatile. They are just going to get you emotional and react. Rarely do we ever make smart decisions when we are emotional.
- Get help. While it is great to invest on your own, having someone to talk to and put things into perspective helps. This is why I started this website. Find people that don’t get scared when the market gets crazy and talk to them.
I go into more detail about overcoming your fear when investing in my post about how to invest when you are scared of the stock market.
Getting The Right Asset Allocation Model For You
Now we get to the good part, how to pick the right asset allocation model for you.
The easiest way to figure out your ideal asset allocation is to take a risk tolerance questionnaire. I like the one Vanguard offers.
But these questionnaires aren’t perfect. You still have to think through the questions they ask. Many people get excited about the questions about potential return when they see the large one year return potential.
And then they discount the potential one year loss potential.
To overcome this, I encourage you to focus more on the questions about losing money. Really think about how you would feel if you lost this amount of money. If the question presents the loss in percentage terms, do the math.
Take your desired savings amount and multiply it by the potential loss. For example, if you want $500,000 in your account and are asked if you are comfortable with a loss of 40%, see how much this is.
Take $500,000 multiplied by 0.40 and see that you will lose $200,000. Are you comfortable with this? Doing the math only takes a few seconds but puts things into perspective.
Keeping Your Asset Allocation In Check
One final thing you need to understand about asset allocation. As the market moves, your asset allocation is going to get out of alignment. Stocks and bonds tend to move in opposite directions.
And not all stock sectors move in the same direction either.
One day large cap stocks might rise while small cap stocks decline. As a result, your ideal asset allocation model is going get messed up. In the short term, this isn’t a big deal. But over time, it is.
For example, let’s say you are comfortable with a 60% stock and 40% bond portfolio. The market gets hot and stocks rise. Because of this, at the end of the year your asset allocation model is now 70% stocks and 30% bonds.
This might not seem like a big deal when you look at how much money you made during the year.
But let’s go back to the chart at the beginning of this post. You chose the asset allocation model of 60% stocks and 40% bonds because you were comfortable with the possibility of losing 26.6% of your money in a year.
But now with your new allocation, are you OK with losing 30.7%?
Probably not, otherwise you would have chosen that allocation instead.
What does this change in allocation look like in terms of money? Let’s say after the great year, you portfolio is worth $15,000.
If the market tanks and the worst 1 year return happens, you would lose roughly $4,000 if your allocation was still in the 60% stocks and 40% bond portfolio you chose.
But if your allocation changed to 70% stocks and 30% bonds, you would lose close to $4,600
That is a difference of over $600!
As your wealth grows, your potential loss only grows larger.
The point is, you need to stay on top of your asset allocation model and make sure you are still invested based on your risk tolerance.
Here are some guidelines for keeping your asset allocation model in check.
#1. Check your asset allocation a few times a year. You should check your asset allocation at least once a year. Typically most people check at the end of the year. If you really want to stay on top of things, you can check twice a year, once in June and then at the end of the year.
#2. Know when to rebalance. Just because your asset allocation is out of alignment doesn’t mean you need to take action. The rule of thumb is any deviation of 5% or less needs no action. This is because most times, it will cost you more in time and money to reallocate your portfolio than you risk losing by not acting.
So, only act if your asset allocation is out of alignment by 5% or more. Here is what this looks like.
If your asset allocation model is 60% stocks and 40% bonds and after completing an asset review you find you have 65% stocks and 35% bonds, you would not rebalance. But if you reached 70% in stocks, then you would rebalance.
What is the best way to rebalance your investments back to your ideal asset mix? Unfortunately there isn’t a one size fits all approach here. This is because retirement accounts and non-retirement accounts are taxed differently.
With that said, here are the best options for rebalancing each type of account.
- To rebalance a retirement account: You would simply sell a portion of your overweight holdings and use the proceeds to buy more of your underweight holdings. This is the preferred method since you can make trades in a retirement account without tax issues.
- To rebalance a taxable account: Here is where things get a little more complicated. You can’t simply buy and sell because any gains you realize when you sell will force you to pay income tax. We don’t want this. So you have a few options to rebalance a taxable account and avoid paying taxes.
The first is to redirect future investments to the asset class that needs to rise in value. For example, if your 60% stock and 40% bond portfolio is 70% stock and 30% bond, you would invest new money into bonds until your allocation was back to your target of 60% stocks and 40% bonds.
Another option is to turn off dividend and capital gain reinvestments. When you do this, any capital gains or dividends you earn will be kept in cash. You can then use this cash to help you rebalance your portfolio back to your target allocation. You could do a combination of both these options to help you rebalance your portfolio faster.
Finally, you could still go the buy and sell route. The catch here is that you need to sell specific tax lots. You want to try to sell some tax lots with gains and offset with tax lots with losses so they balance out and you don’t owe any income tax. But this method is more complicated and most investors are better served going with the other options I listed.
Tools To Rebalance Your Portfolio
Now that you know how and why you need to rebalance your portfolio, let’s talk about a couple of tools that will make the entire process a lot easier for you.
The first option for you is to use an spreadsheet. You set up a spreadsheet with your holdings and then create your ideal allocation. As you update the current value of your investments, you will see where you need to invest more money.
While this spreadsheet gives you full control to see how you are allocated, there is some manual updating to it. Because of this, I have two other options for you.
Personal Capital is a free tool that you use to link your accounts to and they will show you your asset allocation in real time. But it doesn’t end there. They also offer you a detailed look at your net worth, how much you are paying in investment fees, a detailed analysis report on your portfolio, and a customizable retirement calculator all for free!
I use Personal Capital to track my wealth and love using it. You can get started by clicking here.
Using Robo-Advisors For The Right Asset Allocation Model
Finally, if you aren’t comfortable figuring out your asset allocation model on your own, you can invest with a robo-advisor. These firms will walk you through the process and help you to pick the right investment mix based on many factors.
And while this is great, they also will work to keep your portfolio tied to your asset allocation model by rebalancing on a regular basis.
There are many robo-advisors out there and choosing one can be overwhelming. My favorite is Betterment.
They are one of the originals and have some of the best features for the lowest cost. And you can start investing for as little as $10!
Click here to get started with Betterment.
At the end of the day, getting your asset allocation model right is critical to your long term investing success. By ignoring your investment mix, you are going to react emotionally and make rash decisions.
This is not good and only does you and your money harm. So take the time to pick an asset allocation that makes sense for you and watch your investments grow.