Deciding on your asset allocation is one of the most important investing decisions that you will make. The asset classes that you decide to include in your portfolio will determine what you can get out of your portfolio, and your investment experience. As you would expect, there are a lot of people who want to give you a lot of advice about what the “right” allocation is. But almost none of it is good advice. Most people are focused on tactics, or what they think will work in the moment – not what will work in the long run.
Your asset allocation isn’t tactical, and it certainly doesn’t live in the moment. When you set your asset allocation, you need to be thinking long-term, and that means getting back to the basics. You want to start at the beginning: the market portfolio. The market, by definition, is the “average” portfolio. The thing is though, no one is an “average” investor. So, while the market is where you should start when we’re thinking about our asset allocation, you will likely need to make some tweaks here and there to customize it for your situation. You don’t want to make these tweaks too freely though; you should have a clear reason for every change that you make away from the market. There’s absolutely nothing wrong with investing in the market portfolio, and it can be an upgrade for many investors, so you want to think carefully before you tilt away from the market.
However, there will likely be some changes that you’ll want to make to your portfolio. To identify those changes, ask yourself how you are different from the average investor. How do you differ from the market? Because you emphatically are (almost certainly) not the average investor. Exactly how we are different from the market seems like it should be a relatively simple question – you probably live in the US, you’re probably focused on preparing for retirement, etc. – but the answers can quickly get complicated once you start identifying what makes your situation unique, because once you identify how you differ from the average investor, you need to decipher what to do about those differences…What do your differences mean for how you set up your asset allocation?
There are any number of ways that you are different from the average investor, but for our purposes, I want to focus on the two potential differences that I called out earlier. If you’re reading this, you are likely a US based investor (who will be retiring in the US), and there’s an even better chance that you are investing to prepare for your retirement.
Both of these differences can lead you to some pretty important shifts away from the market portfolio. Let’s start with the geographical difference first. Everyone comes from somewhere, and everyone is going to retire somewhere. For the majority of our readers, those two answers will line up. But as an investor, you want to focus on the latter question. Where you are going to retire should inform your asset allocation.
The market portfolio is a global portfolio. The US represents about half of the world’s stock markets, but that means that the other half is outside the US. A market portfolio would mirror this. While where a company is listed doesn’t have a material impact on it’s future expected returns, you may want to tilt your portfolio a little bit towards your home market. Presumably, you’re going to be consuming in that home market, so you want your retirement savings (slightly) more tied to your home economy. There are all sorts of reasons for this, but it’s important to not overdo this (I’m looking at you Australia). You’ll just want to tilt your portfolio towards your home country by a small amount.
Turning to the other big difference you have from the market (that we’re looking at here) – you are probably focused on preparing for your retirement. This has all sorts of effects, though by far the most important effect is that you are likely to have a much longer time horizon than the average investor. Because of this, on average, you are likely to be better able to ride out the short-term bumps in your portfolio than someone who is more focused on what next quarter holds. And this opens up some very interesting doors.
This ability to potentially ride out the short-term noise means that you are able to focus on, and harvest, long-term returns more effectively than most other people in the market. This goes for both your ratio of stocks to bonds, but also what you do with your stocks.
To start with, the bond market is roughly twice the size of the stock market, but very few people have a portfolio that is two thirds bonds, and one third stocks. In fact, the bog standard 60/40 portfolio (60% stocks and 40% bonds) is almost the inverse of this. In the short-term, this can be disastrous – if you disagree, go ask someone who was planning on retiring in 2009 how that worked out for them – but in general, over the long-term, this has worked out pretty well for disciplined investors. However, it’s important to recognize that we’re able to harvest these higher returns because our longer term time horizons give us optionality; we can make adjustments through time if necessary, because tilting our portfolios towards the stock market, and away from the bond market means that we are taking on risk.
Even within the stock portion of your portfolio, your longer time horizon means that you might be inclined to tilt your portfolio towards the risky sections of the market. A portfolio’s expected returns are determined by it’s exposure to certain risks with positive expected returns. Just like your longer time horizon means that you are, on average, better able to harvest the returns associated with tilting towards stocks, that longer time horizon means that you are, again on average, better able to harvest the long-term returns associated with these risk factors within the stock market.
But any changes that you make to your portfolio should be made with a delicate hand. The market portfolio is, for a lot of people, a very good portfolio to be in. You need a good reason to move away from the market portfolio, and if there isn’t a compelling reason to move away from the market portfolio, don’t do it. But there are certain ways that you can likely improve on the market portfolio for your specific situation. And you owe it to yourself to consider what those changes might be.
If you do decide that you are different from the average investor, you can use that to craft the portfolio that will give you the best chance to reach the retirement that you deserve.