Best asset allocation for your portfolio

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This is the first Wise Bread post that I've been afraid to write.

I've thought about it many times, but haven't even gotten as far as making notes until today, when I finally figured out why it was so tough: It's going to be wrong. Five years from now, there's going to be one investment that did better than any other. With the perspective of hindsight, no investment advice will look good compared to "Put all your money into SubprimeHybridSmartphones.com" (or gold or farmland or TIPS or whatever it turns out to be).

Of course, you don't know what that investment will turn out to be. (Guess wrong and put all your money into SolarOrganicBicycles.biz instead and you'll be sorry--except maybe that'll turn out to be the best investment over the next ten years. After all, something has to be.)

The desire to come up with an ideal asset allocation is a strong one. Investing magazines are always making up asset allocations after-the-fact and telling you about three funds that doubled or ten stocks that tripled last year--a useless activity that anyone with an internet connection could do. What we want is the right asset allocation for next year, a want that will not be satisfied, except occasionally by luck.

Given that we don't know the future, what guidelines can we use to make our investment decisions?

Get your financial house in order

Before you do any serious investing, make sure you've got:

1. Your debts paid off (with the possible exception of mortgages and student loans, if they're at low, fixed rates)
2. An emergency fund (with 3-6 months living expenses)

Think about your goals

I've talked before about the False goal of maximum investment return. The purpose of your investment portfolio is to support your life goals. Obviously, to the extent that your goals can be satisfied with money, higher total returns gets your satisfaction earlier. But the fact is, many goals can't be satisfied with money, and for many of the others, early satisfaction isn't as important as certain satisfaction.

The ideal asset allocation for someone who's saving up for a down payment on a house in three or four years is different from the allocation for someone who's saving to put their kid through college in 15 years, which is different from the allocation for someone saving for retirement in 30 years. (They're not completely different, though, especially if at least some of your goals are long-term ones.)

Make a list of your financial goals, and come up with both a rough dollar figure and a target time range for each one.

Except for very short-term goals (saving for a summer vacation or a new sofa), it's a mistake to create different accounts for different goals. What you want is one investment portfolio that supports all your goals.

Create your asset allocation

As long as the economy is ticking along, the stock portion of your investment portfolio is going to provide the bulk of the gains. Because of that, it makes sense to start with a theoretical 100% stock asset allocation, and then work backwards to account for all the reasons that you don't want all your money invested in stocks.

Considerations

First, the economy may not continue ticking along. Stocks entitle you to a share of the company's prosperity--and if the company doesn't prosper, that's not worth much. You want to have some investments that do well precisely when the economy is doing poorly--government bonds, for example.

Second, most investments--stocks, bonds, bank accounts--even cash, when you get right down to it--are really promises. They're promises to pay some specific amount, promises to share (in the case of stocks), or the general promise to provide goods and services in exchange for money. Some of those sorts of promises tend to be kept (US government bonds, for example, have a great record). Others (just lately, subprime mortgage loans) haven't done as well. Sometimes the economy goes through extended periods during which promises aren't kept as well as usual. In those times, it's nice to own something that isn't a promise. The alternative to promises is actual stuff. Owning stuff that you're going to use is often an unbeatable investment. Once you've stockpiled as much as makes sense, then you're talking about things like gold and silver. Real estate is an actual thing, although it's a special case for many reasons. It can be tempting to view companies that produce or own actual stuff as a special case as well, but remember that shares in such a company are still a promise. You want to own some amount of actual stuff, for times when promises aren't doing so well.

Third, many of your goals are not financial, and your portfolio ought to support those as well. For example, sleeping well at night is a goal for most of us, and many people find a portfolio whose value jumps around a lot bad for sleep. Putting some cash and some bonds into your portfolio helps with that. Living in a pleasant community is another goal, as is living in a just society, and allocating some of your investment portfolio to support local businesses, green businesses, and businesses who follow fair business practices can help there.

Finally, although stock investments will likely get you to your goal sooner, unlucky stock investments might not get you there at all. Bonds, on the other hand, can almost certainly get you to your goal (although it may take your whole career).

Numbers

So, what does all that boil down to?

A common rule-of-thumb used to be to subtract your age from 100 to get your stock allocation. So a 20-year-old would put 80% of the portfolio into stocks, while a 65-year-old would have only 35% stocks. The reason is that a 20-year-old can ride out even a long-term bear market. (In fact, a bear market that strikes just as your salary really starts to grow would be perfect, letting you you load up on cheap stocks for years.) Once you retire, though, a bear market is just a bad thing, so it's best not to have your whole investment portfolio exposed to stocks.

Over the past 25 years, stocks have done so well that many advisors have been uping the stock percentage. Personally, I'm reasonably happy with the old rule of thumb, at least for people of working age. I would be inclined to stop reducing the stock percentage when it hits about 35% and just hold it there through at least the first half of someone's retirement.

So, what about the rest of your money? I'd put a tidy chunk (half or more of the non-stock portion) into long-term government bonds. I'd like to have some invested in gold and silver, but I wouldn't be inclined to buy much of either at current prices.

After you've funded your emergency account, there's only two good reason to hold cash in your investment portfolio:

1. To support your near-term goals. As the time approaches to take that vacation or buy that sofa--or as the college-bound child goes to junior high and then to high school--make sure that you're shifting enough of your investment portfolio into cash to be able to write the checks. For things where the time horizon is very flexible, you can let the market dictate when you spend the money--I know one guy who repaved his driveway when our company stock hit an all-time high--but you don't want to find yourself trying to convince your daughter to put off getting married for a few years until the market recovers enough to fund the wedding.
2. To take advantage of market opportunities. This is a good reason in theory, but it's hardly ever a good reason in practice. If you have enough cash on hand to really take advantage of a good opportunity, you're probably missing out on more market gains than your opportunity will provide. Just keep feeding your savings into your asset allocation you've selected.

Here's an example for a 40-year-old:

• 60% stocks (half in an S&P index fund, the rest divided between an international fund and a mid-cap fund)
• 25% bonds (mostly long-term government bonds)
• 10% stuff (stockpiled goods that you plan to use, then gold and silver)
• 5% cash (percentage adjusted to support near-term goals)

Account for your illiquid holdings

Do you already own something that amounts to a major portion of your net worth, but that you couldn't just sell by calling your broker? The two most common things that fall into this category are a house or a business, but there are plenty of other possibilities, such as a large loan to a friend or relative (that you actually expect to be repaid).

Assign a value to the illiquid investment, and include it in your portfolio, in whatever category comes closest. For example, a business probably goes in the category with stock market investments. A house would go in a "real estate" category.

The liquid portion of your investment portfolio should emphasize the investment categories that are most different from your illiquid assets. If most of your net worth is tied up in your house, you wouldn't want to have additional real estate investments.

Account for your debt

Debts that you owe are part of your investment portfolio too. They should be entered as a negative value in the appropriate part of your portfolio (bonds for mortgages and student loans, cash for credit card debt or merchant debt).

That can be kind of a scary exercise. Suppose, for example, a guy has a conservative asset allocation like the one above, and then bought a house. After that, his asset allocation might look like this:

• 60% stocks
• 150% real estate
• -120% bonds (including the mortgage)
• 10% stuff
• 0% cash (drained to make the down payment)

Clearly, this guy is over-invested in real estate and under-invested in bonds (a near universal situation for new homeowners). There's no easy way to bring things quickly back into balance. It would probably make sense to sell some stock to replenish the cash and to pay down the mortgage. The stock is likely to have a better long-term return than the house, though, so I wouldn't reduce the stock percentage a whole lot. Over the long term, paying off the mortgage will bring this portfolio back into balance.

It's worth doing the arithmetic to see what your portfolio looks like with your debts and illiquid assets included. If the results scare you, that will provide a bit of extra incentive to make the necessary adjustments.

Put your investments somewhere

I've written before about not confusing the investments and the compartments to hold the investments in. I've also talked about when to use and when not to use certain compartments. This article isn't about that. It's about allocating your investment dollars among the various investment options.

It'd be nice if we knew which investments would do best, but none of us know the future. Given that, the best you can do is invest in stocks for growth, bonds for the times when growth is hard to find, and stuff, for the days when promises like stocks and bonds aren't kept.

Good luck.