You have chosen the type of investment account and funded it, and now you are ready to invest! The next step is a big one! You need to decide how much you should put in equity (stocks), how much in fixed income (bonds) and how much to leave in cash. Stocks tend to move up or down in a wider band than bonds. Your reward for enduring the wider fluctuations is the higher return potential. It’s the classic risk/reward trade-off. Generally speaking, the higher the risk, the higher the return. We call this mix Asset Allocation and most financial professionals agree that it is one of the most important decisions investors can make!
Deciding on the asset allocation is so important because, as an investor, you would ideally like the risk level of your investments to match your personal tolerance for risk. Every investor differs in their investment goals and their comfort with risk. By risk I mean the uncertainty and potential financial loss in an investment decision. My youngest daughter expressed her risk tolerance when I suggested she open a TFSA and invest her hard-earned wages. Her immediate response was, “but I don’t want to lose any money”. While I can’t guarantee that she won’t lose any money if she invests, I can guarantee that she won’t make any money if it sits in her chequing account at the bank! Risk/reward in action!
So, here are some points to consider when you are making the asset allocation decision:
- What is your investment goal? If you are 20 years old and saving for retirement your mix should look very different (more or all equity) than if you are saving for a new car that you hope to buy in 6 months (more or all fixed).
- When are you going to need the money that you are investing? The shorter the time frame, the more that should go in fixed income. The longer you have the more that can go in equity so that there is time to recover from a drop.
- How much fluctuation in the portfolio can you comfortably handle? If you invest $10,000 and the portfolio drops to $9000 in a few days, will you lose sleep and be tempted to sell the investments? If so, you need more in fixed income to stabilize the portfolio.
- How much money do you need to make to support your lifestyle? If you have more money than you will ever spend then you can choose a more conservative mix. If you don’t, then you either have to accept more volatility with a higher equity mix or reduce your spending. Having a financial plan will help you greatly with this decision as plans show you how long your money will last given your lifestyle and goals.
If you are still unsure about what your mix should be there are two alternatives I would consider. One, is to take the following quiz. The other very approximate method is to base the allocation to equities on your age given that your time horizon shortens as you age. In this scenario, if you are 20 years old then 80% of the portfolio should be stocks (100-20) and 20% in fixed income or cash. If you are 80 years old then 20% should be in stocks and 80% in fixed income or cash. Again, this is a very rough starting guideline and doesn’t take into consideration individual risk tolerance.
One final point is that your ideal asset allocation should be suitable for good and bad markets. In my experience many investors believe they can handle more risk than they actually can. The big test comes during a market correction when I receive panic calls from clients telling me that they are extremely worried and want to change their mix (i.e. sell equities and go to cash). On the other hand, when markets are going up everyone is comfortable with equities and wants more! That is how investors lose money in the market, buying high and selling low! So, choose your mix carefully as it is a VERY important decision.