What Should My Asset Allocation Be?

By Lexington Wealth Management on February 22, 2019

Allocations amongst “Friends”

There is no simple answer to the question, “What should my asset allocation be?” Not only is every person’s financial situation unique, but people have preferences and things like the financial markets are always changing. So how do we answer this very important question?

Let’s look at a couple of scenarios using popular TV characters from the sitcom Friends. For example, the laugh out loud hilarious Joey Tribbiani is an actor in his thirties. He is not married and has no dependents. He tries to save and allocate enough money to his IRA each year, but it isn’t always easy for him to make ends meet. His annual income varies and can be lumpy.

How should Joey be allocating his assets? Hmmm? Well, he should grow his savings for retirement but in reality, he sometimes needs to dip into it to pay for living expenses. Also, when he is able to put some money away and invest it, he hates to lose! From one standpoint, since Joey has a really long time frame, and beyond his day to day living expenses doesn’t have any liquidity needs, the investments in his IRA can be aggressive. However, since the cash he needs to maintain to supplement his income is likely a large percentage of his overall financial picture then his total allocation could look much less risky, probably even outright conservative early in his career. Joey also needs to be able to stay the course through market volatility in his retirement account, because reducing his risk when the markets fall could be more detrimental than choosing a less aggressive allocation initially…Eventually, Joey’s career takes off and he is earning more than he needs which would lead to a very different discussion about his asset allocation!

As a second scenario…

…I’ll use Chandler Bing and Monica Geller-Bing whose unexpected romance leads to a happy marriage and them being the parents of adopted twins. Monica is a chef. Chandler was in IT but now works in advertising as a copywriter. Their income is enough to meet their day to day living expenses, including paying the mortgage on their home. They even have enough money to maximize their annual retirement account contributions and save for college. Monica is not comfortable with market volatility but she understands their need for longterm growth to pay for the twins to go to college and eventually their retirement.

How should Chandler and Monica be invested? Since they have a stable income and the time and patience to ride out at least one market cycle then they could have at least a growth allocation (predominantly equities). If they have separate college savings plans for their children, then those could be even more aggressively allocated while the kids are young.

Now, let’s change their circumstances by saying Chandler’s mother suddenly passes away and he, as the sole beneficiary of her life insurance policy, inherits a large amount of cash. Furthermore, his feelings about this money are different. He wants to protect it and is concerned the markets are nearing what could be the end of a bull market cycle, so they decide to invest this inheritance in a more balanced way. This means their overall asset allocation is also less risky. They could take on more risk, but they don’t want or need to at this point.

In theory…

As shown in these examples, choosing the appropriate asset allocation can be somewhat of an art but there is also portfolio theory to rely on. One investment theory and traditional approach to choosing an asset allocation is life-cycle investing. This theory has three phases: accumulation, consolidation and spending. Generally, people in the accumulation stage, like Monica and Chandler, are younger to middle-aged earners who need growth. They are saving and have also planned for the unexpected, so they have insurance and/or a rainy day fund. In contrast, the spending stage commonly includes retirees, who are not willing to take on as much risk because they have a shorter time frame and a need for current income.

Applying the life-cycle theory can help investors choose an appropriate allocation but in practice and as shown in the examples above the methodology alone is often not enough. Not everyone, like Joey, fits into a life-cycle box. So the appropriate asset allocation might be very different from what is frequently recommended for a given age. In addition, there are many other things to consider, like goals, spending needs and time frame, as well as liquidity, and tax constraints. People also feel very different about money and risk and it is important to consider personal preferences when discussing asset allocation. If it keeps someone up at night to look at their account balance going down, then that factor should be considered. Investors need to be comfortable with an allocation and able to stay the course during turbulent times, which is where the average investor typically incurs irrecoverable losses. And when preferences change, which can happen, then the asset allocation question absolutely needs to be revisited.

There is not one size fits all when it comes to asset allocation.

In conclusion, choosing the appropriate allocation is one important step in the portfolio management process, which also includes selecting investments and doing a financial plan. Since it plays a leading role in protecting your wealth keep asking the asset allocation question!

Elizabeth Lavoie, CFA
Wealth Advisor- Director
Lexington Wealth Management
elizabeth.lavoie@lexingtonwealth.com