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Choosing an Asset Allocation (How Much in Stocks vs. Bonds?)
Ben Felix
Overview
This video explains how to choose an asset allocation, which is the mix of investments like stocks and bonds in a portfolio. It emphasizes that the amount of risk taken significantly impacts expected returns. The video breaks down risk assessment into three key dimensions: behavioral loss tolerance (psychological ability to handle losses), ability to take risk (financial capacity to withstand declines), and need to take risk (the return required to meet financial goals). It also discusses how the nature of risk, particularly volatility versus purchasing power erosion, changes over longer investment horizons, suggesting that higher stock allocations might be safer for long-term investors if they can manage the psychological aspect.
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Chapters
- Investment risk is often defined as the chance of an investment losing value, but this isn't the only way to view risk.
- Choosing an asset allocation, the mix of stocks, bonds, and other assets, is crucial because it determines the level of risk and expected returns.
- Risk is a primary driver of investment returns; higher potential returns usually come with higher risk.
Understanding what risk means and how it relates to potential returns is fundamental to making informed investment decisions and setting realistic expectations.
- Your risk profile is determined by three main dimensions: behavioral loss tolerance, ability to take risk, and need to take risk.
- Behavioral loss tolerance is your psychological capacity to endure market downturns without panicking and selling, which is crucial for sticking with a plan.
- Ability to take risk is your financial capacity to withstand portfolio value declines without impacting your lifestyle, influenced by time horizon, liquidity needs, and other assets.
- Need to take risk is the level of return required to meet your financial goals; if a low-risk investment can achieve your goals, taking on more risk might be unnecessary.
These three dimensions act as constraints and guides, ensuring your investment strategy aligns with your psychological comfort, financial reality, and ultimate objectives.
An example of low ability to take risk is needing to access your entire investment within 5 years to pay for a house down payment, or needing to withdraw 5% of the portfolio annually without other income sources.
- Behavioral loss tolerance is influenced by factors like risk tolerance, risk preference, financial knowledge, investing experience, risk perception, and risk composure.
- Psychometric assessments, like questionnaires, are the best practice for measuring behavioral loss tolerance by assessing your tendencies during market volatility.
- Results from these assessments are relative, showing how your tolerance compares to others, and typically follow a normal distribution, meaning most people aren't extremely risk-tolerant.
- It's important to have an asset allocation you can stick with; selling during downturns can be very detrimental to long-term returns.
Understanding your psychological limits prevents costly emotional decisions, like selling investments at the worst possible time, which can sabotage your financial future.
A psychometric assessment might reveal that you score lower on risk tolerance than you initially thought, suggesting a more conservative portfolio allocation is appropriate for you to avoid panic selling.
- Your ability to take risk depends on your time horizon, liquidity needs, and capacity to absorb losses without affecting your standard of living.
- Longer time horizons, lower liquidity needs, and a higher capacity to absorb losses all increase your ability to take on investment risk.
- Your human capital, or earning potential from work, also influences risk-taking ability; stable employment acts like a bond, allowing more risk with financial assets.
- Conversely, unstable income, which fluctuates with economic conditions, acts more like a stock, suggesting less risk with financial assets.
Your financial situation dictates how much portfolio decline you can realistically withstand, ensuring your investments don't jeopardize your essential needs or lifestyle.
A tenured university professor with a stable salary has high human capital, allowing them to take on more risk with their investment portfolio compared to a freelance graphic designer whose income is highly variable.
- While stocks are volatile in the short term, their risk decreases for long-term investors due to negative serial dependence (bad returns are often followed by good returns).
- Nominal bonds can exhibit positive serial dependence (bad returns followed by more bad returns), especially during inflation, making them riskier over longer horizons than often perceived.
- Stocks, despite higher short-term volatility, are generally better at preserving purchasing power over the long term compared to bonds, especially during inflationary periods.
- For long-term investors, a higher allocation to stocks may actually be 'safer' in terms of preserving purchasing power, even if it means enduring more short-term volatility.
Understanding how risk characteristics change over different time horizons is critical for selecting an appropriate asset allocation that aligns with long-term goals and protects against inflation.
A 20-year investment horizon might see an optimal stock allocation shift from 20% to 50% for an investor concerned about inflation-adjusted wealth, demonstrating that 'safer' for the long term can mean more stocks.
- Compensated risks are those that offer a higher expected return in exchange for taking them, such as owning a diversified portfolio of stocks over bonds.
- Uncompensated risks are speculative risks, like investing heavily in a single stock or industry, which do not offer a reliably higher expected return.
- Investors seeking higher returns should focus on increasing exposure to compensated risks, like diversifying into small-cap value stocks or increasing overall stock allocation.
- It's important to remember that even compensated risks don't always pay off and can amplify losses, especially when using leverage.
Distinguishing between compensated and uncompensated risks helps investors make strategic decisions about where to allocate capital for potentially higher, more reliable long-term returns, rather than engaging in speculation.
Increasing your allocation to small-cap value stocks is an example of taking on a compensated risk, as historical data suggests these types of stocks have offered higher returns over time compared to broader market indices.
Key takeaways
- Asset allocation is a critical decision driven by the trade-off between risk and expected return.
- Your risk profile is a combination of your psychological comfort with losses (behavioral loss tolerance), your financial capacity to withstand declines (ability to take risk), and the return needed to meet your goals (need to take risk).
- Behavioral loss tolerance is a primary constraint; choose an allocation you can stick with through market ups and downs to avoid costly emotional decisions.
- Your ability to take risk is influenced by factors like your investment time horizon, need for liquidity, and overall financial situation, including your human capital.
- The nature of risk, especially volatility versus purchasing power preservation, changes significantly over longer investment horizons.
- For long-term goals, higher stock allocations may be 'safer' in terms of maintaining purchasing power, provided behavioral constraints are managed.
- Focus on compensated risks (like broad market exposure) that offer higher expected returns, rather than uncompensated speculative risks (like single stock bets).
Key terms
Asset AllocationInvestment RiskExpected ReturnsBehavioral Loss ToleranceRisk-Taking AbilityNeed to Take RiskRisk ProfilePsychometric AssessmentHuman CapitalCompensated RiskUncompensated RiskSerial DependenceAutocorrelation
Test your understanding
- What are the three main dimensions that determine an investor's risk profile?
- How does behavioral loss tolerance act as a constraint on asset allocation, and why is it important?
- Explain the difference between an investor's ability to take risk and their need to take risk.
- How does the perception of risk, particularly volatility, change for long-term investors compared to short-term investors?
- What is the distinction between compensated and uncompensated risks, and how should investors approach each?