I’ve done a lot of writing about investing in shares and investing in bonds but not a lot about how to mix the two! This week’s article is about “asset allocation” i.e. how you bring it all together.
Asset allocation is how you split your money across different “asset classes” (stocks, bonds, term deposits, commodities, etc.) to achieve your goals.
For the purposes of this article, I’ll be focusing on how to allocate your money between risky assets (stocks) and safer assets (bonds / term deposits).
What is a balanced portfolio?
Having all your money in shares of one company is not a good idea – that’s intuitive, right? It’s literally having all your eggs in one basket.
So like I’ve mentioned before, it’s great to invest in ETFs that invest in heaps of different companies. This way you get great diversification and are less likely to lose all your money.
But sometimes diversifying just into different companies is not enough. As we’ve seen in recent global financial crises, share prices can all plummet in unison which could leave you much worse off.
So how would you try avoid this?
You’d do it by investing part of your money in other asset classes; ones that will either hold their value or gain value when stocks fall.
You see this in KiwiSaver funds – the more conservative a KiwiSaver fund is, the higher % of its assets will be in bonds or similar investments.
The idea is that, when stocks go down, bonds will hold their value or increase in value which will mitigate the losses by stocks.
This is the idea of a balanced portfolio. When part of your portfolio decreases in value, other parts increase. Having a balanced portfolio will mean the variance in your returns is smaller. We’re straying dangerously close to serious mathematics here, but in general, variance is just how much your returns differ from year to year.
A term deposit earning 4% for 10 years has no variance because it’ll never change, while stock market returns have a lot of variance because they’re constantly going up and down.
Having a perfectly balanced portfolio sounds like an attractive idea. After all, who wouldn’t want to guarantee the same amount of returns guaranteed every year?
But in practice, it’s not something you really need to worry about when you’re young. If you’re investing for the long-term, you can embrace volatility and not worry so much about balance!
So let’s look at how you might approach allocating your investments through your life.
The investing world loves a rule of thumb, and asset allocation is no different.
The old rule of thumb used to be: Start with 100 and subtract your age – that’s the percentage of your money you want in stocks. Put the rest in bonds / term deposits.
This means that, if you were 30, you’d have 70% of your money in stocks and 30% in bonds/term deposits.
However, because we are all living (and working) much longer these days, this rule is out of date.
These days there’s a new rule of thumb. It suggests you take 125 and subtract your age and it’s a lot more popular these days. In practice this means you have a higher percentage of your money is risky assets (stocks) when you’re young and able to withstand the swings. As you get older, you’d gradually put more of your money in safer assets. By the time you retire, you’d have 40% or more of your money in bonds or term deposits.
Does this work in practice?
It’s all very well to say that young people should have the majority of their money in stocks.
Where this fails is that the millennial generation has a deep mistrust of the stock market in general. Studies in the United States show that millennials have the highest % of their money in cash assets (i.e. with a bank). This isn’t surprising at all considering we’ve witnessed multiple massive economic collapses as we’ve grown up and are now very wary of the stock market. As a group, we look at the sharemarket as a great way to lose our hard earned dollars.
Recommending young people invest large amounts of their money in stocks is pretty ineffective because if they experience a downturn when they are young, they might be put off for life (like a lot of us already have been)
People in their 20’s are also likely to be earning less than those in their 30’s and 40’s and therefore are less able to sustain shocks to the share market.
This is why I agree with the notion that for most people, it’s best to start off having a small % of your money in stocks in your 20’s. This way you’re not likely to lose so much money and you get used to what investing is like.
Once you’re in your 30’s and 40’s, you can start investing larger percentages in the stock market. When you’re older, you’ll probably be earning more and your income will be more secure, allowing you to be less worried about swings in the stock market.
Okay, so how do I figure out my asset allocation?
I’m big on the idea that there’s no perfect solution for everyone.
Some people might be able to handle having a large % of their money in the stock market when they are young, but others might not. Asset allocation essentially boils down to “how safe/risky do I want my investing to be?”
This is why it’s so important to know thyself. You need to know how confident an investor you are and what your ability to handle risk is.
If you’re just starting out and still not really sure about this investing thing, it’s completely okay (not to mention sensible) to start with only small %’s of your money in stocks and the rest in term deposits/bonds. This way you can get your feet wet, and see what it feels like to own stocks.
You can also find out how you’d react when they go up/ down. You learn a lot about yourself the first time your investments experience a major downswing! (For example, I freaked out big time)
If you’re already really confident in your investing and know that you’ll be able to handle downturns, it’s fine to start with a significant percentage of your money in the stock market when you’re young.
Remember that it’s not a very good idea to put all your money in at the same time; you want to dollar cost average to avoid mistiming the market. For an in-depth look into dollar cost averaging, check out this article.
Rules of thumb are just guidelines. They’re worth knowing but don’t need to be followed rigorously. It’s not worth worrying too much about having a “balanced portfolio” when you’re young. Now is the time to relax and figure out what works best for you.