Subscribers (new and old) often ask me which of my recommended Portfolios they should follow. It’s a quick question without a quick answer … because making that decision requires that you evaluate both your ability and your willingness to take on risk.
The decision about how much risk to take—how much to allocate between stocks and bonds and cash—is a fundamental decision that has a big impact on your long-term returns and your mental health.
I’ve read studies showing that asset allocation drives 70% to 90% of performance over time. And yet, investors spend far less time thinking about how much to allocate to stocks versus bonds compared to the amount of time and energy poured into selecting one fund over another.
Frankly, I am also guilty of spilling far less ink on this topic compared to fund analysis, so allow me to try and balance the scales a little. I’ll talk you through how I think about risk and help you figure out which of my different Portfolios is best for what you are looking to achieve with your investments. But before I do that, I’ll give you a few shortcut solutions—and tell you why you might want to take the longer way around.
It should go without saying that I’m talking about setting your portfolio up for the long run; short-term outlooks don’t factor in here. If I could reliably time the market’s ups and downs, then you and I wouldn’t have to worry about this—I’d simply tell you when to take risk (and therefore own stocks) and when not to (by holding cash).
Oh, if only it were so.
Now, here’s a fair warning: I am not going to give you “the” answer. My goal is to equip you with the tools that enable to you find an answer that is right for you.
Key Points
- Think about both your ability and willingness to take risk when deciding how much to allocate to stocks or bonds
- You can look to Vanguard’s Target Retirement funds and risk assessment tool for input, but each shortcut has its limitations
- The longer your time horizon, the stronger your financial position and the more comfortable you are with risk, the greater allocation to stocks you can handle
Spreadsheet vs. Real Life
First, let me quickly define some terms that are central to the risk conversation.
Your ability or capacity to take on risk is determined by your time horizon and your financial stability. The longer your time horizon and the stronger your financial foundation, the more easily you’ll be able to weather adverse events and still achieve your long-term goals.
Your risk capacity is fairly easy to evaluate—or at least relatively easy to punch into a spreadsheet. But we live in the real world, where spreadsheets are no use when it comes to emotions. So, the other part of the allocation conversation has to do with your willingness to take on risk. (Sometimes this is called your risk tolerance.) How much of a risk-taker are you? How far can your portfolio fall in value before you deviate from your investment plan?
I’ll take a closer look at these sides of the risk coin in a moment, but first let’s discuss two shortcuts to figuring out which Portfolio is right for you.