Summary: The optimal asset allocation for an individual relies on many factors, but a 50-50 ratio of stocks to bonds works just fine.
Asset Allocation: What to buy, and how much of it.
Let's start off slow. The broadest level of asset allocation is how much stocks vs how much bonds you should have.
Your risk tolerance will be the main deciding factor for ratio of stocks to bonds optimal for you. Technically, you decide what your risk tolerance is, but here are some factors that generally decrease your capacity for risk:
Aging/ closeness to retirement.
Planned large future expenses
Poor health/ medical issues
Being an African-American male **
And of course, the less of the above factors you have, the higher your risk-tolerance goes. But just for fun, I tried to think of some other things that would increase your capacity for risk:
A level of income known colloquially as Fuck-You money†
Intent to bequeath rather than liquidate portfolio
Keeping several months’ of salary in cash keeps you reasonably liquid in case of emergencies.
After considering these factors and where you stand relatively, it’s still not clear what your ratio should be without a baseline. Here are the two most popular ratios used by long term investors to help you decide, or you can just go with them to avoid a hassle.
A Lazy Allocation : % in bonds= age % in stocks = 100- % in bonds
As you age closer to retirement, you slowly decrease your risk profile.
An Even Lazier Allocation: The 50-50 Portfolio: % in bonds = % in stocks
The 50-50 portfolio is a bit too hands-off for my tastes, but popular nonetheless. Historically, this portfolio would’ve grown somewhat less than a 100% stock portfolio but with far less volatility in most 60 year time periods.
In the next article, we will go a level deeper into asset allocation and discuss how you should partition the stock portion of your portfolio.
* This does not have to be innate. Overexposure to the fear-mongering media during bull markets can easily cause you to “tilt” and sell prematurely.
** Black men are at higher risk for many health problems, not to mention violence, arrest, racial prejudice etc. If you think political correctness is relevant to risk-analysis, GWS101 is that way, enjoy your liberal college experience.
† When you have more money than you’ll ever need, wealth preservation and insurance against black swan catastrophes take priority over growth. Thus, the game changes considerably.