By Humberto Cruz
, Contributor 
ASSET ALLOCATION means splitting your investments among different 'asset classes' that do not all go up and down at the same time.
The three major asset classes are stocks, bonds and cash equivalents. Stocks have provided the highest return over time, but pose the biggest risk of loss. The main purpose of asset allocation at its most basic level, finding the most appropriate split among stocks, bonds and cash, is to achieve the best combination of risk and return.
Now as to how to do it. I dislike simplistic formulas, such as subtracting your age from 110 and allocating that percentage to stocks (for example, at age 50 you would put 60 per cent of your money in stocks).
While useful as a starting point, these formulas, if followed blindly, can lead to totally inappropriate decisions.
FIRST BLUSH
Instead, I favour the approach advocated by Larry Swedroe, principal of Buckingham Asset Management in St. Louis, who recommends you ask yourself what at first blush may seem like one question, but is really three: how much risk are you able to take, how much risk are you willing to take, and how much risk do you need to take?
"We teach our clients they need to identify each of these three," said Swedroe, who expands on the topic in his new book, The Successful Investor Today: 14 Simple Truths You Must Know When You Invest. "They are like the legs in a three-legged stool, and all three legs must be touching the floor firmly."
In other words, as a general rule, you shouldn't take any more risk than the least you are able, willing or need to take.
Let's amplify. Your ability to take risk is determined by two factors: your "time horizon," or how long you can leave your money invested, and the stability of your earned income. Many risk tolerance questionnaires focus on the first factor while almost ignoring the second.
"If your income is unstable, you may have to sell stocks at the wrong time," that is, when they are down, Swedroe said. "If you find yourself unemployed while watching the stock market go down, you are more likely to be susceptible to panic. On the other hand, if you are a tenured professor, you can have a greater ability to take risk."
Having the ability to take risk, however, is not enough.
"If your stomach doesn't let you sleep well during a bear market, you are more likely to panic and sell" even if your time horizon is long and your income from work is stable, Swedroe said. His general advice (and mine): Life is too short, and no investment is worth losing sleep over. (As a guideline, Swedroe's book suggests you put no more than 30 per cent of your portfolio in stocks if you are not willing to risk a loss greater than 10 per cent. With an all-stock portfolio, you should be willing to lose 50 per cent).
Then there is a question of need. Perhaps you have so much money already that the interest from government or other highly rated bonds will give you all you need for life. If so, why take the risk of investing in stocks?
"You should never take more risk than you have the need to take," Swedroe said. "At some point you have enough."
But what if you have no savings and realise now you need the highest returns that stocks have provided over time if you ever hope to retire?
"Then you are going to have to accept the fact you are going to have to save more, live more frugally or delay retirement," Swedroe said. "Or buy a 10-year supply of Maalox and learn to live with the risk of stocks."
His advice (and again mine): It is much better to discipline yourself to save more and live on less than to try to make up for lost time by loading up your portfolio with more stocks than your ability or willingness to take risk would suggest.
"My answer is don't do it, because you are going to panic" and sell at the bottom, Swedroe said. "You are better off living a less expensive lifestyle."
Taken from the South Florida Sun-Sentinel
