Answer These 4 Simple Questions
Everyone talks about “asset allocation” – spreading around your assets into different buckets in order to reduce risk. At the highest level, it comes down to how much you put in stocks and how much you put in nonstocks (bonds, real estate and cash). So how much stock should be in your portfolio? In other words, given that stocks generally carry the most risk in a portfolio, how much risk should you be taking?
Certainly not a “one size fits all” answer, since everyone’s financial situation differs, the right amount of stocks for each individual will vary too. In general:
- Younger investors can afford more stock risk.
- Clients with higher income can afford more stock risk.
- Clients with a greater net worth can afford more stock risk.
- Clients who understand and desire more risk can incorporate this into their mix.
How do you translate these concepts into a specific allocation to stocks (such as 60% or 75%)? For years, financial advisors have used “Mean Variance Optimizers (MVO)” to generate the answer. An MVO is highly sophisticated software that considers how each asset class has performed and how much it has moved relative to all the other asset classes. The MVO also uses assumptions for inputs like interest rates, inflation and mortality. In short, the financial advisor loads the MVO with client-specific data (age, income, net worth, risk tolerance) and the MVO spits out an allocation.
After using and studying MVOs for years, I’ve concluded:
- An MVO’s outcome (say, to ideally have 55% in stocks) is still only an approximation.
- In fact, you can vary this number up or down about 7% and not significantly alter your long-term outcome. So this 55% single- number outcome becomes a range of 48% to 62%.
- It takes lots of client and financial advisor time to complete the MVO process.
- Clients generally have no idea how their inputs affect the MVO’s outcome.
Is there a back-of-the-envelope way to approximate an MVO’s output? Borrowing from online asset allocation sites (like the one used by the SEC*), I use four simple questions (see sidebar).
Based on my personal example, the percentage of stocks for my accounts should be somewhere near 60%. Given the +/- 7% range, my stocks ought to be anywhere from 53% to 67%. Of course, this is only an approximation – use of an MVO and other tools will get you even closer.
And that’s an average stock percentage. Look for information about varying your stock percentage as long-term market trends change in a future column.
The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results.
Asset allocation and diversification do not guarantee a profit or protect against a loss. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
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