Optimal Asset Allocation

Can be achieved with the right asset allocation advice!

The optimal asset allocation is very much dependent on where you are in your life cycle, whether you are working or retired, and what the nature of your near-term expenses might be.

Common asset allocation advice to determine your ideal asset allocation is to subtract your age from 100 to get your stock allocation. So a 20-year-old would put 80% of the portfolio into stocks, while a 65-year-old would have only 35% stocks.

The reason is that a 20-year-old can ride out even a long-term (10 year) bear market. Once you retire, it's considered best not to have your whole investment portfolio exposed to stocks as cash may be needed to live on.

This might apply particularly to 401k asset allocation and asset allocation in superannuation funds.

You don't want to be selling shares to fund day-to-day retirement expenses when share prices are at rock bottom!

Of course, these percentages are moderated by the amount of assets available to invest.

The Best Optimal Asset Allocation

With people living longer, a 35% allocation to stocks for a retiree can be considered too low by some (and by me) as a longer anticipated life span provides a greater opportunity to ride out any downturns.

This assumes that you have sufficient funds in cash to live on in the meantime.

Access to cash to fund living expenses for three years plus any major expenses anticipated in that time period is a good buffer in case of a downturn in the market.

An asset allocation chart is a useful visual device to help you decide how to allocate your funds to different asset classes, and the proportion to each class.

Charts can be used to match different risk profiles from very conservative, to moderately conservative, to moderately aggressive, to very aggressive.

I exist down the aggressive end of the allocation spectrum as I am confident in my investment ability, and I sleep soundly. You need to make an appropriate judgment about your own risk tolerance.

Value investing, as compared to speculating in the stock market, gives the investor this confidence.

Asset Allocation Book

A book titled Understanding Asset Allocation by Victor Canto (see link above at right) provides a somewhat easy to use approach to achieve optimal asset allocation.

The book provides information to allow the investor to decide the right times to choose particular asset classes.

These asset classes include passive versus active investments, value versus growth stocks, large caps versus small cap stocks, for example.

Testing Your Risk Tolerance

Going through (and surviving) a number of stock market crashes helps to test your risk tolerance. Asset allocation adjustments can then be made with more confidence.

If you can handle higher risk, you can benefit from higher returns from your investments during the upturns.

Asset Allocation Funds

Asset allocation funds are single mutual funds that allocate funds across a range of asset classes such as cash, stocks and bonds.

The Vanguard Asset Allocation Fund is an example of this type of fund. It seeks to maximize long-term total return (share price growth plus income) while incurring less stock-market risk than a fund made up entirely of stocks.

This type of fund may be useful for investors who need help in matching the level of volatility in their investments with their risk profile.

To Conclude

Risk and volatility mean different things to value investors. Optimal asset allocation in a value investing context is more about what level of volatility you can handle in your overall investment portfolio.

Risk, and its minimization for value investors, relates more to achieving a margin of safety when purchasing stocks in order to limit or hopefully eliminate any downside in the stock price.

Reducing volatility in an investment portfolio is more important for (usually older) investors who need access to some of their funds for their everyday living expenses.

It may also be important for younger investors who want to be confident that they can access funds in the short to medium term to make a major purchase, such as a home to live in, regardless of where the stock market is positioned.

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