Asset Allocation: The Key to a Healthy Portfolio

Diversify your portfolio. You’ve heard it before. But what is the best combination of investments? What percentage of your portfolio should be in stocks? Bonds? Real estate? Gold? How should you weigh the pros and cons of foreign and domestic investments? Should the allocation be different depending upon whether the account is your practice retirement plan, your IRA, or your taxable investment accounts? When doctors stopped by my booth at the 2007 Star of the North Meeting, their most frequent and fervent questions were about asset allocation.

Financial planning is a blend of art and science. There is no consensus in the investment community on the single best way to approach asset allocation, but there are academically validated methods to assemble financial portfolios. When I work one-on-one with clients, we design a unique plan based on specific life goals, risk tolerance, current asset holdings, and retirement dreams. Asset allocation is a key to achieving the long-lasting financial security every doctor
hopes for.

Goals, Timeframe, and Risk Tolerance: What Works for You?

How soon do you want to be financially independent? Do you know what it will take to get there? The longer your time horizon, the higher level of risk you can incur today. If you are 35 and plan to work for 30 more years, you have the luxury of years to absorb short-term losses. If you are closer to retirement and are on track to accumulate enough assets to be financially independent by the age you’re aiming for, you can dial down the risk level in your portfolio.

Investment volatility means potentially greater gains — and pitfalls. How much loss can you stand before you bail out and sell an investment? We all want big financial rewards; however, risk tolerance is a highly personal preference. If you are an aggressive investor, you are willing to accept more risk in exchange for the opportunity to get a higher return. If the idea of market volatility and financial loss keeps you up at night, a more conservative approach is probably for you. Protect your principal and enjoy incremental gains with peace of mind.

Once you reach retirement, asset allocation takes a new spin. Consider this: You’re 65 today. Assuming a modest three percent inflation rate, by age 85, today’s 41 cent stamp will cost 74 cents. Today’s $30,000 automobile will cost $54,183. If a $1,000,000 bond portfolio yields five percent ($50,000/year), and inflation is three percent, over time the $50,000 of annual interest on your bonds will not keep pace with inflation, and your purchasing power — i.e. your standard of living — will decline. Inflation is the enemy of a fixed income portfolio, and you need a portion of your portfolio protected against it. Stocks are an asset class that has a real return against inflation. So, in retirement you should still maintain a significant portion of your portfolio (50-70%) in stocks.

Weighing Options, Making Choices

To assemble a diverse portfolio, you are most commonly working with stocks, bonds, and cash. It is as important to allocate funds within each asset category as it is to diversify between them.

Stocks

Of the three major types of assets, stocks (that is, ownership in a company) have historically the highest return and the greatest risk. Your risk tolerance will figure into your choices concerning which stocks to invest in. However, regardless of your taste for risk, stocks (or equities) should figure prominently in your portfolio.

Domestic vs. foreign, small cap vs. large cap, value vs. growth. Over time, different kinds of stocks gain and wane in popularity. Since it is impossible to predict ahead of time which type of stock will fare best over the next three to six to 12 months, it is best to have some money allocated to each. While the return on the portfolio will never be as high as if you had all your money in what turns out to be the best performing area, your losses will never mirror the poorest performing area.

One issue I see in portfolio construction is concentrated stock positions; that is, having a large part of the portfolio in one stock. This concentration is often the result of an inheritance, a spouse’s employee stock purchase/plan or 401(k), or even from a long-time holding that has done well and become a very large holding — a situation that often leads people to be reluctant to sell off a portion. Concentrated stock positions raise the volatility of a portfolio. If you have one stock making up 10% of your portfolio, this should raise a red flag. Twenty percent or more? Trim the position.

Bonds

Bonds are a money-lending vehicle. Corporate bonds lend money to corporations, municipal bonds to cities, treasury bonds to the U.S. government. During the life of the bond you receive interest payments, and at the end of the term you are paid back your principle. Bonds are less volatile than stocks, in part because as long as the entity to which you loaned your money to remains able to operate, you get the money you originally loaned them back. It is important to have both stocks and bonds in your portfolio as bond values vary at a slower rate than stocks and help smooth out the bumps. They also add to diversification because they have a low correlation with the stock market. During the last eight bear markets going back to 1968, when stocks as measured by the S&P 500 were down an average of 25.2% per bear market, bonds, as represented by five-year treasury bonds, were actually up an average of 9.8%. In the dark days of a bear stock market, asset diversification will help you sleep better.

Within the bond market itself there are different types available, including investment grade bonds and high yield bonds. Bonds also vary by duration: short-term, intermediate, and long-term. The longer the duration, the more sensitive the bond is to fluctuations in interest rates. Municipal bonds, which when issued by governmental entities in your own state are free of state and federal taxes, are often a good choice in taxable accounts.

Cash

Call it cold, call it hard, cash is what it is: money in a savings account or money market fund. Cash won’t earn much return, particularly when measured against inflation, but these assets will not lose value.

More Considerations

• Like bonds, real estate and commodities have a low correlation with stocks and can help smooth out the ups and downs.

• Any assets you don’t want to own? For example, many health care professionals are not comfortable owning tobacco stocks.

• The asset allocation you choose today should not be static. If you are 40, and plan to work to age 65 and believe a portfolio that is 90% stocks and 10% bonds is right for you, it would be wise to reevaluate the allocation at, say, age 45. Despite a bull or bear market in the interim, reevaluation is necessary because you are now five years closer to retirement.

Stick to Your Plan

Once you have worked through your goals, your time horizon, your risk tolerance, and decided upon your asset allocation percentages, write it down. A written Investment Policy Statement (IPS) will help you stay on course and maintain a clear vision for your portfolio.

If you have decided that an allocation of 80% stocks and 20% bonds is a good fit, and the stock market subsequently goes down 30% in value, you may be tempted to sell your stocks and bail out of the market. This action falls under the classic investor error of buying high and selling low. Referring to your IPS will help you remember why you chose the 80/20 allocation and stick to it. By the same token, if you’ve started with an 80/20 mix and the stock market goes up such that your portfolio is now 90/10, reviewing your IPS will help you rebalance by selling stocks when they are up and returning the portfolio to 80/20.

The underperformance of the average investor is not just a numbers game, it is a direct impact on quality of life. The question is, how long will you work before you’re financially independent? Choosing to stay gainfully employed certainly beats being chained to the dental chair.