Portfolio Building Basics: Asset Allocation

As I mentioned in my previous post, for the average DIY investor, a passive investing strategy is the most optimal – it produces the most reliable result with the least effort from the investor.

Is implementing passive investing completely effortless?

Well, you will need to do a bit of homework before starting. That homework is determining your asset allocation.

Typically, the four main asset classes are:

  • Bonds
  • Stocks
  • Real Estate Investment Trusts (REITS)
  • Commodities

In this article, I will only talk about stocks and bonds which are the two main asset class for your portfolio. In my next article we will explore the other asset classes, sub-classes and rebalancing your portfolio.

I will first talk about what is asset allocation and I would discuss factors that affect your allocation mainly your risk appetite, your ability to take risks and your needs.

Curry and Rice: An Analogy

You are hungry. However, your favorite Indian restaurant which you frequented is closed today, of all days.

So you decide to try this new Indian restaurant just opposite your office.

However, because this is a new restaurant, you are not sure you can handle the spiciness. You can only enjoy a moderate amount of spice beyond which will become a torture rather than an enjoyment.

The last time you tried a new restaurant, the ‘medium spicy’ curry was too much for you to handle.

So this time, you try a new strategy to manage the spiciness. So you requested the curry and rice to be served in separate bowls.

You will then take a small portion of curry and mix it with a large portion of rice in a 20/80 ratio of curry to rice. Now you find the heat bearable and the meal rather enjoyable. This is because the rice helps reduce the heat from the curry.

If the meal does not give you a kick, you instead reverse the portions and mix in a 80/20 ratio of curry to rice. Suddenly, the meal becomes exciting.

Stocks are like curries, they are exciting, unpredictable, has potential to give you the most returns but also has the potential to burn you. They provide excitement (randomness – great gains or great losses) to your portfolio

Bonds are like rice, they are boring, predictable, provide steady gains enough to fill your stomach and help dampen the losses due to stocks. They provide safety and stability to your portfolio

Asset allocation is like the art of mixing your rice and curry – you try to find the right proportions to suit your risk appetite

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Factors That Affect Your Asset Allocation

#1 Your Risk Appetite

Are you naturally a risk taker or risk adverse? Do you have the fortitude to stick with the investing strategy when the going gets tough?

Similar to your tolerance to heat, this varies from individual to individual.

Here is a general guideline on how much stocks to allocate depending on your risk tolerance

A suggested allocation based on risk tolerance

#2 Your Ability to Take Risks

Your ability to take risk, is dependent on the resources at your disposal, namely

  1. Your time available for investing – investment time horizon
  2. Your labour capital – income generation ability
  3. Your need for cash – do you need liquidity

Having more of these resources gives your more time to grow your investments, helps you recoup your losses and allows you to remain invested even when the market crash.

#2.1 Investment time horizon

The longer the horizon, the more you can wait out a bad year (or several bad years) until your returns go back to positive. This is holding power of the individual.

Also, the longer the time horizon, the longer time your investment can grow to recoup the losses.

Here is a general guideline on asset allocation based on investment time horizon.

A suggested allocation based on investment time horizon

#2.2 Human Capital – Income Generation Ability

The higher and more stable the income you generate, the more you are able to take on bigger losses and hence greater risk.

If you have a stable high paying job – like a doctor, lawyer etc etc, you can afford to be more aggressive because you can easily afford the losses and recoup them quicker.

Having more disposal income helps as more money generates even more money.

These professions are like bonds that generate fixed income (and high yield!). So they can allocate more of their portfolio to stocks.

If you are a freelancer, business owner or commission-based agent you have more uncertainty in your income and will not be able to afford losing money.

These professions are like stocks that may generate a huge amount or low amount with no fixed certainty. So they can allocate more of their portfolio to bonds to help generate fixed incomes for more stability.

If you are young and healthy, you may have more income generating ability. If you have specialized and valuable skillsets, you may have more income generating ability. Those factors contribute to ability to take risk.

#2.3 Need for Liquidity

The thing about passive investing is that you will need to leave your money in the stock market for it to grow. However, there are instances where we might need the cash immediately, especially when going through huge life changes.

When you get married, have children or relocate or emigrate to a different country or changing life circumstances due to illness or accidents, you will need more liquidity. Those are the factors that affect how much risk you can take.

So if you know you might be going through some big life changes, you might want to allocate less to risky stocks and more to bonds.

The good news is that we can prepare for such situations such as buying insurances or having an emergency cash fund for unanticipated expenses. This will increase our ability to take risks.

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#3 Your Needs

The last factor that will affect your asset allocation is your needs. What is the goal which you are trying to achieve via investing?

Sometimes, you will need to take more risk (or less risk) to achieve your goals regardless of your risk appetite (or even risk ability).

Here are two scenarios to illustrate this:

First scenario: You already achieve financial independence and retired early at the age of 30 with a huge net worth of several millions. You are living a comfortable life and have several passive source of income from your portfolio. You still have a huge risk appetite and continue to invest aggressively. However, at this point you should stop to ask yourself what would you benefit from that incremental wealth? Think about how much more harmful if you lost 30-40% of your total wealth? You may need to cancel retirement and go back to work. Your asset allocation should align with your needs instead. Your goal should be captial preservation instead of capital growth.

Second scenario: You are really risk adverse and would rather put all your savings in fixed deposit. You are a highly paid professional and yet without increasing your risk you know you will not accumulate enough to retire and live off your savings. Rather than align your asset allocation to your risk adverse nature, you should invest more aggressively in order to meet your retirement goals.

In Summary

An important step in constructing your portfolio is defining the asset allocation to bonds and stocks.

Your asset allocation should match your risk appetite, your ability to take risk and your needs. It should be unique to you.

Everything written here is merely a guideline. There is no definitive formula or a right way to do it. Finding the right mix of assets is both an art and a science.

Happy tinkering with your portfolio. Let me know if you have any comments

If you want to dig in deeper, this book is a great guide. Note, this is an affiliate link so I will receive a commission for any purchase.

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Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!