Post #13 – The Importance of Equity Allocation, Part III
In Post #12, I discussed the importance of managing your investing emotions through maintaining your portfolios volatility. This is done by deciding on the appropriate percentage equity allocation. Deciding on the proper asset allocation is a very important decision for every investor. It is also a personal decision as each person’s risk tolerance is different. In this post I will provide a couple of suggestions as to how you might make this decision. I have included the table from Post #12 for you to consider once again.
Return of Different Equity Allocations for 20 Years from 1990 to 2009
|
Equity Allocation |
100% Fixed Income |
10% Equity |
20% Equity |
30% Equity |
40% Equity |
50% Equity |
| Average Annual Return |
5.9% |
6.3% |
6.7% |
7.2% |
7.6% |
8.0% |
| Worst Calendar Year |
-4.4% |
-3.8% |
-3.3% |
-6.1% |
-10.5% |
-14.9% |
| Cumulative Worst 3 Calendar Years |
6.0% |
8.6% |
11.2% |
8.0% |
0.7% |
-6.6% |
|
Equity Allocation |
60% Equity |
70% Equity |
80% Equity |
90% Equity |
100% Equity |
| Average Annual Return |
8.4% |
8.8% |
9.3% |
9.7% |
10.1% |
| Worst Calendar Year |
-19.4% |
-23.8% |
-28.2% |
-32.6% |
-37.0% |
| Cumulative Worst 3 Calendar Years |
-13.9% |
-21.2% |
-28.5% |
-35.8% |
-43.1% |
Equity Portion is S&P 500 Index Including Dividends
Fixed Income is 30% ST Treasuries & 70% Intermediate Treasuries
Portfolios “Re-balanced” Annually
A Logical Approach
An approach you might try is to start with the 100% equity column in the above table and review the cumulative worst 3 year return. Assess how you might feel if we experience another 3 year bear market in stocks. If you don’t feel comfortable with a 43.1% reduction in your portfolio value over 3 years, then move to the 90% equity column and make the same assessment using the 3 year 35.8% loss figure. If you are still not comfortable with a 35.8% loss, then move to the 80% equity column and so forth. When you find the column where the 3 year loss figure is one that you could tolerate, then that is likely the appropriate equity allocation for you. I suspect, after experiencing the recent financial crisis, most people in their 50s and 60s will settle on an equity allocation of 40% to 60%.
A Simple Formula
A simple formula to determine your equity allocation that I think would suffice for the majority of retail investors is one that has been around for years. It is the formula my father and grandfather used and told me about when I first started investing in the 1970s. Many financial advisors and brokerage firms think this formula is out-dated, but I disagree. The volatility of the markets in the past decade I think prove it is still applicable. It is:
Your Equity Allocation = 100 Minus Your Age.
According to this formula, a 30 year old should have an equity allocation of 70%, a 50 year old should have an equity allocation of 50%, and a 70 year olds allocation would be 30%. If you can stick with this formula, remembering to adjust your allocation every 5 years as you age, you should do fine.
The important thing to remember is once you select your equity allocation, you should stick with it, changing it only as you age. Investing is about discipline and patience.
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