How to Calibrate Your Asset Allocation & Reach Your Financial Goals

According to financial industry studies, more than three-quarters of portfolio performance and volatility is related to asset allocation.

Asset allocation is one of the most crucial decisions in investing. Arguably, no other decision will have a larger effect on your portfolio's performance and volatility. It's the "template" for your investments; it governs the destiny of your wealth creation. 

An asset allocation policy divides a portfolio's investments among different asset classes, the most common being stocks, international stocks, bonds, real estate and cash.

Your investment strategy should start with an asset allocation plan tailored to your specific needs. Once in place, it will guide your choices when buying and selling investments. If designed properly it can also provide an easy and transparent way for you to determine how your investments are performing.

Before you establish your portfolio's asset allocation, ask yourself these questions:

1. What is the purpose of my portfolio?

First and foremost, you need to define your portfolio's purpose. Be honest with yourself. 

You may want to generate a lot of money over the short term so you can buy a house. Or maybe you want to generate reliable cash flow because you're getting ready to retire. It may be important to you that you grow the family estate for your kids and grandkids. Or you might be excited about accumulating ample cash to invest in an entrepreneurial investment opportunity. 

Your goals should be based on what you want from your investments.

2. What stage in life am I entering?

Choose a category based not only on your age, but also on your intestinal fortitude. As recent history shows, you’ll probably have to withstand periods of extreme volatility at some point in the future. Even if you're relatively young, you may not have the wherewithal to remain disciplined during such times. You may just be naturally conservative, and that's okay. Once again, be honest with yourself.

3. How much do I already have, and is my financial position likely to get better, worse, or remain the same?

Take stock of your current net worth and see how close you are to your ultimate goal. If you have a head start, are you comfortable taking more risk because you have built up a safety net, or would you rather take less risk because you don't want to lose what you already have? 

Having a secure job also affects your financial position. Can you count on steady income and for how long? If you're afraid of getting laid off, you may want to significantly ratchet down your risk profile or set aside a significant portion of your portfolio in an emergency fund. 

4. What rate of return do I need to reach my goals, and what amount of risk am I willing to tolerate?

Generally speaking, people get more conservative as they get older, mainly because they have fewer working years in front of them.  If your portfolio takes a turn for the worse when you’re in your 40s, you still have plenty of time to bounce back. But if your investments take a nosedive when you’re 65, you’re in a far worse predicament.

If you have a specific dollar goal in mind, you can calculate the rate of return you'll need to achieve to reach it (click here to use the InvestingAnswers Compound Annual Growth Rate calculator). For example, if you have $1,000,000 today but you want to have $2,000,000 in 10 years, you know you'll need to average a return of 7.18% per year to reach your goal.

5. Are there regulatory requirements that take decisions out of my hands?

Don’t be blindsided by the rules and regulations dictated by most retirement accounts. If your portfolio is an Individual Retirement Account (IRA) the mandatory distribution requirements will be.

6. What are some example portfolios that I can reference to get started?

As noted above, the basic asset classes available to individual investors include stocks, international stocks, bonds, real estate (via Real Estate Investment Trusts) and cash (i.e. money markets). The appropriate percentages depend on your answers to the questions above. 

Here are some example portfolios, which you can then tweak according to your specific situation:

Goal Risk Tolerance Stocks International Bonds REITs Cash
Stability Conservative 0% 0% 15% 0% 85%
Income Moderately Conservative 5% 5% 60% 5% 25%
Moderate Income Defensive 10% 5% 60% 5% 20%
Growth & Income Moderately Aggressive 45% 15% 20% 10% 10%
Growth Aggressive 50% 20% 10% 15% 5%

When setting your asset allocations, it's important to stay focused on the big picture, not the markets’ quarter-to-quarter roller coaster rides. Having an asset allocation plan in place can help you steel your nerves and reach your investment goals.

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