Saturday, March 3, 2007

The Investor's (Asset Allocation) Dilemma

I'm 35 years old, as is my wife. Most folks our age seem to have little, if nothing, in bond mutual funds & everything in stock mutual funds. In fact, a majority go further and use leverage, options, individual stock picks, etc. to juice the risk & potential reward of their portfolio.

And me? I'm trying to decide which Asset Allocation (AA) in the range between 50/50 to 70/30 between stocks/bonds I want to reside.

I freely admit to cowardice in this regard. I believe in the long-term potential of the stock market and reject market timing. And yet...

... it appears to me that the stock market's general P/E level is quite high. Worse, investor optimism is extremely high, which suggests that the risk premium for today's market is lower than historical levels.

All this is pointing me towards where I believe I'll land: an allocation that is 60% in stocks, 40% in bonds. I'll be fairly conservative in my bond portfolio too, holding the Total Bond Index with a current average duration of about 4 1/2 years.

I will ask you, Gentle Reader, a simple question to help you find the right AA for you.

Assume that, in any one year, you may see a decline of up to 50% in the stock portion of your portfolio. A cool half.

That is, if you have the 60/40 portfolio I mentioned above, there may be a year when you will lose (60/2) = 30% of the value of your portfolio.

If 80% of your portfolio is stocks and you start the year with $200,000, then your portfolio may drop to $120,000.

Question: Do you stay the course with your AA in this situation? Do you buy more stocks to replace the losses or try to shift into something "safer"?

If you answer "yes" to the 1st question, your allocation is fine. If not, you need to lower it 10 points and ask the question again. Stop when you hit a point at which you will not change your plan.

"Stay the course" is the best long-term you'll ever have. Make sure you have the right AA & 80% of the job is done.

2 comments:

TFB said...

Great new blog! I'm subscribing to your feed and adding you to my blog roll.

Orthros said...

Thanks TFB. Let me know if there are any specific topics you're interested in.

If I actually know anything about them, I'll whip something up. :D