Maybe you have seen them from your broker…those online surveys that are supposed to help you decide on your asset allocation based on your risk tolerance. Maybe you should think twice before using them. As the U.S. Securities and Exchange Commission (SEC) puts it, “While the suggested asset allocations may be a useful starting point, keep in mind that the results may be biased towards financial products or services sold by companies or individuals sponsoring the websites.”
Besides the potential for bias, the surveys themselves are limited because they only help you understand your risk tolerance, which is the willingness to take risk. To make the right decision about your allocation, you need to include two other important aspects: ability and need…and, you need to consider all three separately.
Regarding willingness, I reviewed most of the free questionnaires (I avoided those you would have to pay or register for) and found two that give you an unbiased result. Each one took me around 5 minutes to get results. Here they are:
Possible risk profile outcomes are Low Tolerance, Below-average Tolerance, Average/Moderate Tolerance, Above-average Tolerance, and High Tolerance
Possible risk profile outcomes are Very Defensive, Defensive, Conservative, Moderate, Moderately Aggressive, Aggressive, and Very Aggressive
Take both questionnaires, which may give you different results, then assess your general willingness to accept risk within the below four groups. Using their definitions, here is how we will translate them:
- Conservative = Low Tolerance, Below-average Tolerance and Very Defensive, Defensive
- Moderate = Average/Moderate Tolerance and Moderate
- Moderately Aggressive = Above-average Tolerance and Moderately Aggressive
- Aggressive = High Tolerance and Aggressive, Very Aggressive
After you finish the assessment for willingness, let’s consider ability to take risk. If you are carrying any high interest debt, or have a significant amount of consumer debt (not mortgage debt), then you might have a low ability to take risk. You may have some ability, even with debt, if you are contributing just enough to get the employer match on a 401k, but debt limits your ability to take on risk. You should apply savings to reducing your debt, starting with credit cards and other high interest debt, before considering investments. Even if you have no consumer debt, what happens if you need immediate access to your savings, or if you are within a short time of reaching your savings goal? Your savings goal may not be reached it if its value can fluctuate so greatly that the total is not there when you need it. For example, you saved $15K for a car, but you put it all in the stock market, and now there is a bear market right before you plan to make the purchase. In short, ability to accept a loss affects your ability to take on risk. What if you have a very modest income, you have children or elderly parents who depend on your financial support, or you do not have an emergency fund yet? You are not able to take on risk. Here is generally how you should think about ability using the four categories defined previously:
- Conservative = Consumer debt payments that are no greater than 10% of annual net income, and no need to access investment funds for at least 5 years
- Moderate = Consumer debt payments that are no greater than 10% of annual net income, and no need to access investment funds for at least 7 years
- Moderately Aggressive = Consumer debt that is zero, and no need to access investment funds for at least 7 years
- Aggressive = Consumer debt that is zero, and no need to access investment funds for at least 10 years
If you are “below” the Conservative parameters or have a very modest income, you should probably have no money in risky assets. Pay down consumer debt first, and better still, consider not investing at all until you have zero consumer debt. These are general guidelines. Consider your specific situation and exercise judgment.
Let’s say I have a high willingness and ability to take on risk. I have been investing for 30 years and have been through multiple bear markets, have no debt, and I do not have to access most of my savings for a long time…but, I have more than enough in pensions and savings, and I do not need to take on very much risk to maintain the lifestyle I enjoy, even after considering the effects of inflation. Contrast this with a young investor who has many decades to go before needing money for retirement. The young have a need to take on risk. To earn the highest potential rate of return, the young may decide to assume the highest degree of risk to maximize their portfolio’s growth potential.
- Conservative to Moderate = Low need
- Moderately Aggressive to Aggressive = High need
Putting it Together
Now let’s consider all three together – willingness, ability, and need – and decide on the allocation between stocks and bonds. It is likely the three ratings will not be the same, but you can now apply some judgment in a comprehensive manner. If one rating is more conservative than the other two, normally you should use the most conservative rating for the overall rating. For example, willingness determines whether you can stick with your chosen allocation and not abandon it at the worst possible time (a bear market). In that scenario, your need and ability mean little if you do not have the willingness to stick with the plan.
Based on your final chosen risk profile, choose your stock/bond allocation based on these ranges:
- Conservative = 20-35% Stocks, 80-65% Bonds; Average: 30% Stocks, 70% Bonds
- Moderate = 35-55% Stocks, 65-45% Bonds; Average: 50% Stocks, 50% Bonds
- Moderately Aggressive = 55-70% Stocks, 45-30% Bonds; Average: 60% Stocks, 40% Bonds
- Aggressive = 70-80% Stocks, 30-20% Bonds; Average: 70% Stocks, 30% Bonds
You may have multiple savings goals, such as college, new car, and retirement. If so, then you should evaluate each goal separately using willingness, ability, and need. Then decide on the overall allocation. Never hold less than 20% in either stocks or bonds. Outside of the 20% band, the risk/reward ratio between stocks and bonds is not in your favor, regardless of your tolerance for risk. If you cannot tolerate at least 20% in stocks, then you should consider the choice of not investing in the stock market at all.
Human error is the most common reason investment plans go off the rails. If you take your time on this step and carefully consider your willingness, ability, and need to take on risk, you will have confidence to stay the course and meet your savings goals, even if that means not investing in stocks. The consequence is that if you do not hold stocks, be prepared to save much, much more for your retirement!