Today we conclude our series on how best to make asset allocation decisions. It's an easy decision when
the analysis of your ability, willingness and need to take risk leads to the
same conclusion. For example, one can have
a high ability and willingness to take risk but little need. In that case, the
answer is simple: Because the marginal utility of additional wealth is likely low, the
need to take risk should dominate the decision.
However, conflicts often get in the way, making the choices more difficult. Consider the following situation:
Philip is an extremely nervous
investor. His willingness to take risk would probably produce an equity
allocation approaching zero. He knows, however, that a very low equity
allocation is apt to produce very little, if any, growth in the real value of
his portfolio. This directly conflicts with his personal objective to retire
within 10 to 15 years.
To attain this objective, Philip knows he must take more
risk, so he chooses an equity allocation of at least 80 percent. The lower the
equity allocation, the longer he would have to continue working. His
willingness to take risk proved to be in direct conflict with his personal
goals. For Philip, there was no correct answer to this conundrum. He would
have to choose which of his objectives would have greater priority -- the need
to sleep well or the desire for early retirement.
Ultimately, Philip decided his early retirement objective should take priority. He realized this decision was apt to produce those sleepless nights and that his ability and willingness to stay the course might be sorely tested.
Choosing the higher equity
allocation (taking more risk) was the right choice for Philip, but it might not be
the right choice for you. In general, I recommend choosing the lowest equity
allocation derived from the three tests (ability, willingness and need) and then altering your goals. For
example, if you find you have a higher need to take risk than your ability or
willingness suggests, your plan should use the lower equity allocation
recommended by the ability and willingness to take risks.
Otherwise, if the risks show up -- in the form of bear markets or negative events such as divorce or job loss -- the plan will fail and you may not be able to successfully adapt to the change in circumstances. The alternative is to lower your goal, save more now and/or plan on working longer.
Keep in mind that the more options one
has, the more risk one can take. Having said that, before taking a higher level
of risk, make sure you are truly willing to exercise those options. For instance, while it
may be possible to move to an area that has a lower cost of living, if your spouse doesn't
want to leave the grandchildren, it won't happen.