Know Thyself or Risk Losing More Than You Can Afford

by Inya Ivkovic, MA

As many of us have learned the hard way, coveting stock market returns can cost you a pretty penny when the mighty pendulum swings in the wrong direction. Unfortunately, opting for safe and boring fixed income investments when the world of equities is skyrocketing into the stratosphere is often unthinkable. Still, the beauty of hindsight is that, once a lesson has been learned, the same mistake won’t be repeated. Or, you’ll fit Einstein’s definition of insanity and keep on doing the same thing over and over again, each time expecting a different result.

So, fixed income investments are an obligatory part of every portfolio — got that! But how much money should go into them? If only there were a simple answer. Of course, that doesn’t mean there isn’t an answer. It only means the right answer for you will depend on a number of variables.

For starters, most financial advisers agree that allocating a portion of your portfolio in fixed income investments should be part of your financial plan, which, once devised, should not be altered just because another asset class is temporarily doing exponentially better. Otherwise, your portfolio is governed by emotions, not reason, and that would be another big “no-no” of investing.

Still, what about that balance of fixed income investments versus equities? One of the most commonly used rules of thumb is “age rule.” For example, if you are 40 years old, put 40% of your portfolio into fixed income securities and 60% in equities. If you are 60, for example, the proportion between two asset classes should be in reverse. The idea is that, the older you get, the harder it is to recover from stock market downturns. As a form of insulation against unrecoverable stock market losses, the fixed income portion of your portfolio should increase with your age.

I agree, on the face value of it, this formula sounds like something a fifth grader could come up with. But remember Occam’s razor, whereby the simplest solution tends to be the right one. For what it’s worth, at least this rule is a reasonable starting point for the asset allocation discussion of your portfolio.

There are other variables that need to be considered when applying the age rule to asset allocation. Today, people can retire as early or as late as their savings allow them. Plus, their lifespans have changed, with longevity increasing in the past few decades or so. These variables will impact to what degree your age will correspond to how conservatively you diversify your portfolio. These days, many people strive for “Freedom 55,” while they also generally live longer, so their money must work much harder than what fixed income investments can offer. So, regardless of one’s age, 65% invested in fixed income should be the absolute maximum weighting for that asset class.

Finally, have an honest look at your risk profile. When your financial advisor asks you some tough questions about how much risk you can take, answer them truthfully. The idea is to establish your pain threshold, which will again help determine how conservative or how aggressive your portfolio is going to be.

There are six broad investment profiles determined based on an investor’s risk tolerance: capital preservation, income generation, balanced, growth, and aggressive and speculative profiles. At the ultra conservative end of this spectrum are clients concerned with capital preservation, who have been known to put as much as 85% of their money in fixed income securities. Speculative portfolios are at the opposite side, whereby we have seen such investors putting as little as five percent in fixed-income securities, and sometimes a grand total of zero percent.

Again, the key to establishing the right balance for you is to consider your investment objectives (what you want your portfolio to do for you), the length of your investment horizon (within what timeframe you want your investment objectives reached), and how much risk you can really tolerate along the way. By sticking to your plan, you will be comparably well-insulated from market fluctuations, and your investments will be governed by reason, not emotions. And the best part is that, as your life circumstances change, so does your investment plan. Don’t forget; you can always rebalance and adjust your investments to suit you best.