Risk tolerance and asset allocation

July 9, 2014

Ryan McLaughlin,

When building a portfolio, the first decision is your desired asset allocation. How much of your portfolio is to be invested in each asset class (stocks and bonds)? Your allocation should be determined by your tolerance for risk. Your tolerance for risk is determined by the flexibility you have with your financial goals and your comfort with volatility.

Financial Flexibility: Chris is a construction worker. He’s 57, and each day he is increasingly aware that his body unlikely will be able to continue in this line of work for more than two more years. Between his Social Security and savings, Chris feels his expenses will be covered only slightly. Chris can neither delay his retirement nor reduce his expenses; he has a low ability to take risk. Denise is 54. She hopes to retire at 62 with enough to provide for $40,000 of annual spending. Denise likes working, so she wouldn’t mind having to work into her late 60s. And $40,000 is just a goal. She knows she could get by just fine with less than that. Denise’s goals are more flexible, she has greater ability to take risk.

Volatility: Risk tolerance is also affected by your comfort level with volatility. Ask yourself, “How far could my portfolio drop before I started losing sleep and wanting to sell everything and move to cash?” What would you do if your portfolio declined by 25% or more? When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative, you’ll only be missing out on a relatively small incremental return. If you end up with a portfolio that’s too aggressive, you may panic during periods of high volatility. One instance of getting out of the market after a sharp drop can be enough to eliminate the extra return from having a stock-heavy allocation.

Stocks Vs. Bonds: Once you have an idea of your risk tolerance, you need to determine your allocation. A rule of thumb that serves as a starting point is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, assume that your stocks can lose 50% of their value at any time. The most important thing to remember with asset allocation guidelines are that they’re just that: guidelines. With regard to this particular rule of thumb, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified.

Rebalancing: Rebalancing is the act of adjusting your holdings to bring them back in line with your original allocation as a result of the market moving up or down. A periodic rebalancing program essentially automates the old saying, “buy low, sell high,” as you’ll be selling the portion of your portfolio that has increased in value so that you can buy more of the portion that has decreased in value. How often should an investor rebalance? Some advocate rebalancing once your portfolio is off balance by a certain amount (such as a stock allocation being 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals, regardless of how off-balance your portfolio becomes in the interim. One rebalance a year is typically sufficient.

Ryan joined CGI in the fall of 2003, after spending 5 years working in investment sales. He graduated from the University of New Hampshire with a Bachelors Degree and, in addition to his life & health insurance license, Ryan is also FINRA Series 7, 63, 24 and 65 licensed. Ryan has also attained his Qualified Plan Financial Consultant designation from the American Society of Pension Professionals and Actuaries. Ryan specializes in the review and implementation of 401(k) and retirement plans, in addition to individual financial planning, he can be reached at 603-232-9317.

Categories: Finance