How to approach asset allocation and risk tolerance.

Asset Allocation when investing

As your investment portfolio grows, you will be faced with the decision on where you want your assets to be invested. The age old advice is to diversify. In other words, do not put all your eggs in one basket. You should spread around your risk so that if one of your investments takes a dive, the remaining investments will offset that loss, or even make gains. But how does one make this decision? Here are some helpful things to think about.

Types of assets to diversify into.

There are more classes of assets out there than you might think!

A lot of young people don’t quite understand the variety of different assets that can be invested into. They look at the traditional domestic mutual funds and ETFs that give them exposure to the stock market, with some fixed income mixed in to control risk. They put their money in these funds, whether in their IRA/401k or TFSA/RRSP, and that’s it! This is a very simple approach and there’s nothing wrong with it. Studies show that money passively invested in an S&P 500 passively managed index fund (investing in the largest 500 public companies in the US) provides strong 8-10% annual returns over long periods of time. But what other asset classes are out there which you didn’t think of? Here are a few to ponder, especially for those who are younger and can stomach a little more risk:

  1. International Equities
  2. ETFs with exposure to non traditional indexes and emerging fields like Space Travel, Biotechnology or Electric Vehicles
  3. Crowdfunded real estate platforms (Addy, Fundrise to name a few)

Risk Tolerance

When you meet with a financial advisor to discuss your investment goals and strategy, one of the things they will do is a “Know Your Client” form. This will ask you to input your tolerances for a variety of investing outcomes. It will ask questions like, how comfortable would you be if your investments on average returned 10% per year, but some years they are down 20% and others they are up 30%. These situations are hypothetical and in my opinion very hard to navigate absent experience.

Risk tolerance is based heavily on the emotional impact that investing has on an investor. Some people have very significant anxiety when they see the stock market dip and their investment fall in value. Others see the long game and are comfortable with short term volatility, even seeing it as an opportunity to buy more “on the dip”.

The best way to determine your own risk tolerance is by getting experience. Try investing small but significant amounts of money into different asset classes and see how their performance makes you feel. When I invest into money market securities which return less than inflation, I get anxiety that my wealth is being eroded away. At least in a real estate or equity investment I have the confidence that over long periods of time, my investment returns are virtually guaranteed to perform at a rate higher than inflation, despite the risk of short term value drops.

Once you invest for a few years into some different classes of assets that carry different risks and levels of volatility, you will learn which ones you most resonate with.

Risk allocation by age

Generally speaking, you want to be allocating more of your investment portfolio to riskier assets early on in your investing journey. This is because higher risk equates to higher returns. When you are young you have more time to endure market volatility – in other words you aren’t impacted if your retirement savings dip 20% when you are 20, but such a dip could be very challenging if you are 75.

Therefore, allocate more of your investments to risky asset classes like stocks and ETFs when you are young. I am now 35 and still have virtually nothing allocated to lower risk securities like bonds or money market. With inflation now at levels unseen in a long time due to money printing to combat covid economic impacts, it is ever more important to be earning rates of return that maintain or grow wealth and protect against inflation’s erosion of wealth.

Leverage Impacts

Some of your investments come with associated debt. This adds risk to the investment because if the asset value falls, the debt stays constant (and you still owe it). You should be looking at the allocation of your net worth by category, which incorporates both the allocation of your assets and your debts. For example, you might have a stock portfolio of $100,000 and a rental property worth $300,000. At first glance it seems like you have 25% of your wealth allocated to stocks and 75% allocated to rental properties. But if the rental property has a $200,000 mortgage on it, you really only have $100,000 of equity in the property ($300,000 value less $200,000 debt). Therefore, in the latter case you are really 50/50 between stocks and rental properties.

Pick a debt to equity ratio which works for you for both individual investment categories and for your portfolio overall and stick to it.

Takeaways

Asset allocation is personal, just like a lot of personal finance topics. Find out what works for your own emotions and risk tolerance and be true to yourself. If you can’t enjoy life with too much risk in your portfolio, it isn’t worth it. At the same time, not enough risk comes with the downside of not keeping up with inflation. Find your balance.

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