As fun as finding winning shares is (and trust us, it really is fun), your allocation to shares (equities) is only one slice in your total investing pie. Asset allocation basically comes down to how much you should have in cash and how much in shares. The Fool’s three rules for asset allocation will help you slice up your portfolio into these important pieces. Rule 1: If you need the money in the next one to five years, it should be in cash. Choose a term deposit or a high interest savings account. You don’t want the deposit for your…
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As fun as finding winning shares is (and trust us, it really is fun), your allocation to shares (equities) is only one slice in your total investing pie. Asset allocation basically comes down to how much you should have in cash and how much in shares. The Fool’s three rules for asset allocation will help you slice up your portfolio into these important pieces.
Rule 1: If you need the money in the next one to five years, it should be in cash. Choose a term deposit or a high interest savings account.
You don’t want the deposit for your European adventure, or your kid’s school fees to evaporate in a share market crash.
Keep it in a term deposit or a high interest savings account. As with any product, shop around for the best rates.
Rule 2: Any money you don’t need within the next five years is a candidate for the share market.
We Fools are fans of the share market. Over the long-term, shares have consistently outperformed the returns on cash and most other forms of investment, the only possible exception being property.
Of course, in the short run, no one knows what shares will do. But make no mistake: Even if you’re in or near retirement, a portion of your money should be invested for the long term. That’s because, a 65-year-old can expect to live another 20 or more years. A 110-year-old, however, should sell everything and get to Vegas while he still can. (We’re kidding… mostly.)
So unless you’re a 95-year-old skydiver who drinks and smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should…
Rule 3: Always own shares.
Over the long term, shares are the best way to ensure that your portfolio withstands inflation and your retirement spending.
In the US, according to Jeremy Siegel’s Stocks for the Long Run, since 1802 US shares outperformed US bonds in 69% of rolling five-year investing periods (1802-1807, 1803-1808, etc.). The percentage of the time that shares wallop bonds only improves as you look over a longer horizon.
|Holding Period||Shares Outperform Bonds|
Data from Stocks for the Long Run, by Jeremy Siegel.
In the US at least, for holding periods of 17 years or more, shares have always beaten inflation, a claim bonds can’t make.
The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? That favourite term among financial gurus: your tolerance for risk.
Risk drives return
Most people base their investment strategies on the returns they want, but they have it back to front. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It’d be great if we could get wonderful returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we’ll lose money.
So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you’re retired, can you rely on other resources such as your Superannuation or the Age pension, or would you have to go back to work or downsize your living arrangements (and how would you feel about that)?
Your answers to those questions will lead you to your risk tolerance. The lower your tolerance for portfolio ups and downs, the more cash you should hold.
As an extra aid in determining your mix of shares and cash, consider the following table, from William Bernstein’s The Intelligent Asset Allocator:
|I can tolerate losing ___% of my portfolio in the course of earning higher returns||Recommended % of portfolio invested in shares|
So, according to Bernstein, if you can’t stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in shares. Sounds like a very good guideline to us.
OK, you now know how much you should have in shares. But what kind of shares — large caps, small caps, value, growth, international? And how much?
Over in the US, we use these charts as a guideline for basic allocations, based on where you stand on your lifelong investing journey.
Note that bonds aren’t nearly as popular or widespread here in Australia as they are in the US. In fact, accord to the September 2010 Reserve Bank of Australia Bulletin, Australian households’ direct participation in the bond market is less than 1% of all Australian bonds on issue.
We’d suggest using Term Deposits as a decent substitute for Bonds.
Action: Determine how much you should invest in shares. Just use Bernstein’s table above. And remember that our appetite for risk changes depending on current market and personal circumstances. So err on the conservative side if you’re taking this quiz during a bull market (and vice versa).