In our previous article, “Understanding asset allocation”, we focused on the questions “What is asset allocation?” and “Why is it important?”. In this article, we provide an overview of what is most important when choosing your target asset allocation or investment risk exposure.
At the highest level, we measure risk exposure by how your investment wealth is divided between defensive (low risk) and growth (higher risk) investment assets. In “The asset allocation decision” we explained that your mix between defensive and growth assets should be determined after a careful weighing up of the following sometimes competing considerations:
- Your appetite or attitude to risk – sometimes called your “risk tolerance”;
- Your need for risk – the level of risk you need to take to give the best chance of achieving your financial objectives; and
- Your capacity for risk – your ability to recover from adverse investment outcomes.
We refer you to that previous article for a fuller discussion of each of the above decision inputs. However, as discussed below, investor behaviour during the Global Financial Crisis has since caused us to both refine the concept of a target asset allocation and the priority we give to the above decision inputs in making the asset allocation decision.
Traditional thinking on asset allocation
The traditional view on asset allocation tends to be that young adults can afford to take more investment risk since they have time to recover should initial investment performance prove to be poor and/or their personal circumstances not evolve as originally projected. Consequently, the advice is that they should hold heavily growth oriented investment portfolios.
However, as investors approach retirement they have less time to recover from adverse investment markets, and the suggestion is they should progressively reduce their allocation to growth assets (and investment risk). By retirement, they should achieve a mix of defensive and growth assets that they intend to maintain for the rest of their lives.
This thinking underpins “target date” funds that are hugely popular in the US and becoming more so in Australia. The fund manager reduces the allocation to growth assets to a target level that varies solely with the investor’s age or expected years to retirement. The approach implies that there are a number of age dependent asset allocation targets.
In our opinion, this traditional view and “target date” funds, in particular, are seriously flawed. Other than the investor’s age or retirement expectations, no account is taken of individual circumstances and lifestyle expectations.
For example, some 45 year olds may have already maximised their income earning potential in their field of employment (e.g. teachers, some investment bankers and business executives) while others have their best earning years ahead of them (e.g. medical specialists, partners in law and accounting firms). It is unlikely that they should have the same target asset allocation, despite being the same age or years to intended retirement.
And, as discussed in our next article, “Measuring your asset allocation”, the simplistic way asset allocation is traditionally measured means that the difference between your current pre-retirement asset allocation and a desired retirement target asset allocation provides little guidance as to how you should transition from where you are now to where you want to be.
There is only one “target asset allocation”
So, what do we think your “target asset allocation” should be. Our view is that there should be only one “target”. Your maximum target growth exposure should be no greater than your attitude to risk will allow you to live with (i.e. to “sleep well”, no matter what investment markets are doing) once you are relying solely on your investment wealth to meet all future expenditure. This generally coincides with retirement.
Unless your attitude to risk changes, your target is unlikely to vary with age. As we will explain in our next article, most young accumulators will not be anywhere near their target asset allocation. Generally, given the way we measure investment wealth, they will be significantly overweight defensive assets. Their challenge is to choose an investment strategy that is designed to achieve their target by retirement (and/or financial independence), with the best chance of meeting (or exceeding) their lifestyle expectations.
Why do we place so much emphasis on attitude to risk in setting your target asset allocation? It is largely driven by our observation that during the Global Financial Crisis many of those who were carrying more growth assets than consistent with their risk appetite abandoned their investment strategy, even though it may have been consistent with their assessed need and capacity for risk.
If your emotions don’t let you stick with a well conceived strategy when times are tough you give up a clear decision making approach for one based on how you feel. From a financial perspective, making investment decisions “with your heart, not your head” is unlikely to be successful over the long term. From the viewpoint of your psychological wellbeing, it will almost certainly be a disaster.
We therefore maintain that your attitude to risk should set the upper bound for your target growth asset exposure. In our next article we will elaborate on the above discussion when we explain how you should measure your current asset allocation.
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