It's amazing how much time is devoted to this subject in the financial media. Everyone seems to be trying to answer to the question: how do I get the most return for the least amount of volatility? The problem with that question is there is no one right answer. A "one size fits all" ideal asset allocation does not exist, and more importantly, asking that question in the first place puts the cart before the horse.
The real question should be: what do I need to pursue my goals? And that can only be answered by actually figuring out your goals and making a plan to get there. Once that plan is developed, the asset allocation of a portfolio is actually one of the last -- not the first -- issues to be addressed.
There are more financial goals one could plan for than there are days in the week. Examples include: college funding, a second home, purchase/sale of a business, a successful retirement, or a tax-efficient legacy plan. If we use the "successful retirement" goal as an example, the steps to get to a properly allocated investment portfolio would go something like this:
1. Determine what you'll need from your portfolio to help meet your living expenses in retirement. Do this in today's dollars. Start by estimating your annual expenses, and then subtracting your other sources of income in retirement, such as Social Security, pensions and rental income.
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2. Inflate this number by 3 percent -- compounded by the number of years you have between now and retirement. Like death and taxes, inflation
is almost unavoidable.
3. Take that result and divide by .04 or .05 -- which will give you the amount you will need to accumulate by the time you retire. This assumes you will withdraw 4 to 5 percent from this portfolio for the rest of your life without exhausting it, which is a financial planning guideline, but not a guarantee.
4. Add the amount you expect to save for retirement to the value of your current retirement portfolio.
5. Calculate the rate of return needed, from now until retirement, to get the sum in Item #4 to equal the value in Item #3. (Note: Most people can't do this without the help of a "present value" calculator or a good financial planner).
6. The resulting rate of return will then determine your "ideal" portfolio.
The hypothetical example above is for illustrative purposes only, and does not represent any investment or investor situation. No strategy, including asset allocation, can ensure a profit or protect against a loss.
The above is an overly-simplified exercise, to be sure, but the point is that goals should drive the investment plan -- not chasing after the latest "hot" stocks -- when seeking to maximize returns. And avoiding volatility is an equally dangerous game, because staying in cash to avoid some of the usual dips in the market will very likely prevent earning the returns necessary to meet your goals.
It's hard for some to believe, but the biggest enemy in retirement is not volatility of one's investment portfolio: it's meeting the rising costs of living. Both of these can be addressed with a well-constructed financial plan.
So the next time you find yourself getting caught in the trap of trying to "beat the market" or "retreat to safety" in the quest for the "ideal" portfolio, do yourself a favor and find a good financial planner, have them construct a financial plan for you and follow their advice.
Karin Grablin, CPA, is with SRQ Wealth Management, 1819 Main Street, Suite 905 in Sarasota, 941-556-9004. SRQ Wealth Management and LPL Financial are not affiliated with UPromise.