III. Goals-Based Asset Allocation

An essential element of a financial plan is how to invest the funds you have saved to maximize the likelihood of achieving each of your goals.  This is the science and art of trading off risk and reward—in asset allocation.  I advocate goals-based asset allocation based on your unique time frames and temperament.

The idea of goals-based investing is this.  Start with the time frames for each of your goals and take into account your Investment Temperament profile to arrive at the asset allocations best suited for each of your goals.  You can think of the process for arriving at suitable allocations in three steps:

  1. Risk/return probabilities optimized to time frame
  2. Fine tuning based on your financial circumstances, to set baseline solely on objective factors
  3. Adjustments to this baseline to accommodate your investor temperament

I provide an example of this general framework in the series of tables below.  Let’s start by talking about why time frame is the first consideration in asset allocation.

Time Frame in Goals-Based Asset Allocation

Very simply, you want to go after the highest expected returns, with a high likelihood of actually achieving these returns in the time you have to work with.  In the sections on Understanding Risk and Taking Advantage of Time Frame, we illustrated how one aspect of risk, namely volatility in the market prices of investments, can and should be measured and evaluated in accordance with your time frame.  Historically, asset classes with higher returns over the long term have also tended to have returns that move around more in the short term.  As a result, you need to think about expected returns and the likelihood of actually achieving those returns over the specific time frame you have to reach a financial goal.

The allocations I outline follow from the logical conclusions drawn from the exercise we walked through in the Taking Advantage of Time Frame section.  To recap, from our analysis of returns for four different asset classes—large cap stocks (S&P 500), small cap stocks, 10-year Treasury bonds and 3-month Treasury bills (a cash equivalent)—we were able to make some important observations:

  • With an investment horizon of 20 years or more, which is often the case in retirement investing, you have an extremely high likelihood of generating the highest return with stocks—stocks outperformed government bonds in 99% of the 20-year stretches in our historical study. With 20 years, our study also showed that small cap stocks returned more than S&P 500 stocks 71% of the time, and 10-year Treasury bonds more than Treasury bills 70% of the time.
  • With a time frame of at least 10 years, there is still a high probability that stocks will return more than bonds—this was the case in 84% of the 10-year periods we studied. With 10 years, our study also showed that small cap stocks returned more than S&P 500 stocks 63% of the time, and 10-year Treasury bonds more than Treasury bills 66% of the time.
  • Finally, with a time frame of 5 years, which asset class provides the best return becomes not much more than a coin toss.

In short, this math—relative returns and the probabilities of achieving them over different time frames—is the objective foundation for asset allocation decisions.

Because each of your goals has its own time frame and time frame is the first input in optimizing the reward/risk trade-off in this manner, I believe each of your goals should have an asset allocation specific to its time frame.  This is what I mean by goals-based asset allocation.  This allows you to see very clearly how you are progressing toward each goal.  Moreover, as the risk (volatility) taken on in the portfolio for each goal corresponds to its time frame, you will feel more comfortable about the funding status for each goal.  As an example, while a retirement fund may be significantly impacted by a stock market rout, there is 20 years of additional runway; on the other hand, the funds for a child’s college or a down payment for a house required in a few years are little impacted, as they are invested in low volatility assets, primarily bonds, in keeping with this short time frame.  In both cases, you’re okay, and you’ll feel okay!

In short, this approach helps mitigate the chance for bad timing—of market declines coinciding with the arrival of a major expenditure goal.  A major improvement in a number of financial planning applications in the last few years is the availability of goals-based planning and asset allocation.  With goals-based asset allocation, you still have an overall asset allocation, but it is simply the aggregation of your goals-based portfolios.  So, it is built from the bottom up.

Stability and Flexibility in Your Financial Circumstances

In addition to time frame, which is an element common to all investors, there are other objective factors you want to take into account, and these relate to the particulars of your financial life.  Our lives are characterized by uncertainty and volatility, just as financial markets are.  But certain life circumstances lend themselves to greater stability.  For example, certain careers have greater job security and more steady income.  Predictable income streams from sources other than salary and investments, now and in retirement, also result in greater financial stability.  On the other hand, high debt loads increase vulnerability to adverse circumstances, like loss of income or unexpected expenses.  Finally, people vary in their flexibility in adapting to changed circumstances.  An important example in financial planning is willingness to delay a planned retirement date.

The Investor Temperament questionnaire, therefore, leads with questions to evaluate the stability and flexibility of your financial circumstances, in order to “score” your objective capacity to accept risk.  This score and the time frame for each of your goals can set a baseline asset allocation for that goal, based solely on objective factors.  The tables below show an example asset allocation framework in this manner.  Note that I think it makes sense to use different parameters for retirement and interim goals, thus the two tables.  This is because the time frame for retirement is actually in two-steps, the savings/investing in the lead up to retirement and the draw down of funds in retirement, which in and of itself we plan on being (and hopefully is) a long period (20+ years).  As a form of “short-hand” for asset allocation, I simply indicate the percentage of stocks in the portfolio, as a telling headline for the risk/reward.  The baseline asset allocation for 1-3 year goals includes no stocks.

Table 2a: Baseline for Retirement Goal: Objective Factors of Timeframe + Risk Capacity
# of Years Until Retirement     
<5 (or Retired) 5-9 10-14 15-19 20+
Risk Capacity High 60% Stocks 70% Stocks 80% Stocks 90% Stocks 100% Stocks
Above Average 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks
Average 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks
Below Average 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks
Low 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks
Table 2b: Baseline for Interim Goals: Objective Factors of Timeframe + Risk Capacity
# of Years to Reach Goal   
1 2 3 5 7 8-9 10-14 15-19 20+
Risk Capacity High 1 Yr Goal 2 Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 80% Stocks 100% Stocks
Above Average 1 Yr Goal 2 Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks 70% Stocks 90% Stocks
Average 1 Yr Goal 2 Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 80% Stocks
Below Average 1 Yr Goal 2 Yr Goal 3 Yr Goal 3 Yr Goal 10% Stocks 10% Stocks 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks
Low 1 Yr Goal 2 Yr Goal 3 Yr Goal 3 Yr Goal 10% Stocks 10% Stocks 20% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks

For simplicity and clarity, I actually use the above asset allocation “short-hand”—the percentage of stock in the portfolios and the portfolios specific to 1-3 year goals—as the names of the Model Portfolios I introduce later.

Accommodating Your Investor Temperament

From this baseline asset allocation based solely on objective factors, I believe a well-designed asset allocation must make accommodations for subjective considerations that can greatly impact your success, namely your investor temperament.  You can think of the baseline allocation as that which would maximize the probability for the best outcome in a given time frame, without regard for what the volatility may be during that time frame.  As if you were to board a plane and quickly fall into a heavy sleep, awaking at your destination oblivious to how turbulent or smooth the ride may have been.  In reality, however, we all see the ups and downs of financial markets and must live with the interim swings in our portfolios from month to month and year to year.  An “optimal” portfolio can prove disastrous in practice if a decline shakes you so much that you bail at a bad time.  Thus, I think it makes sense to make adjustments to the baseline asset allocation to increase the likelihood you remain within your emotional tolerance limits during the stretches of market adversity you will surely face.

The bulk of the Investor Temperament questionnaire, therefore, attempts to gauge your temperament as an investor, specifically to “score” your emotional ability to stick with a plan in the face of a near-term decline in the value of your portfolio.  This score is used to amend the objective baseline allocation to arrive at a final recommendation of the Constancy Investment Portfolio best suited to each of your goals.  To elaborate, the baseline allocation is unchanged for those likely to be unfazed by downside volatility, i.e. those in the “High” category.  I progressively suggest moving to lower volatility portfolios which best fits your Investor Temperament category.  I would emphasize there are no right or wrong, better or worse categories with respect to Investor Temperament.  We all have different personalities, and this applies in the realm of investor behavior as well.  The whole point is simply to pitch the risk/reward trade-off at a level likely to keep you within your emotional comfort zone.

The tables below again show general parameters for asset allocation reflecting adjustments to take into account investor temperament.  Again, you will see two tables, as I think it makes sense to use different parameters for retirement and interim goals, given the two-step nature of the retirement goal.

Table 3a: Model Portfolio for Retirement Goal: Modifying for Investor Temperament
Baseline Allocation on Objective Factors
20% Stocks 30% Stocks  40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks  100% Stocks
Investor Temperament High 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks 100% Stocks
Above Average 20% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks
Average 20% Stocks 30% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks
Below Average 20% Stocks 20% Stocks 20% Stocks 20% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks 50% Stocks
Low 20% Stocks 20% Stocks 20% Stocks 20% Stocks 20% Stocks 20% Stocks 20% Stocks 30% Stocks 30% Stocks
Table 3b: Model Portfolio for Interim Goals: Modifying for Investor Temperament
Baseline Allocation on Objective Factors
 1 Yr Goal 2 Yr Goal  3 Yr Goal  10% Stocks 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks  100% Stocks
Investor Temperament High 1Yr Goal 2Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 30% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks 100% Stocks
Above Average 1Yr Goal 2Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 30% Stocks 40% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks 90% Stocks
Average 1Yr Goal 2Yr Goal 3 Yr Goal 10% Stocks 20% Stocks 20% Stocks 30% Stocks 40% Stocks 40% Stocks 50% Stocks 60% Stocks 70% Stocks 80% Stocks
Below Average 1Yr Goal 2Yr Goal 3 Yr Goal 3 Yr Goal 10% Stocks 10% Stocks 20% Stocks 30% Stocks 30% Stocks 30% Stocks 40% Stocks 50% Stocks 50% Stocks
Low 1Yr Goal 2Yr Goal 3 Yr Goal 3 Yr Goal 10% Stocks 10% Stocks 20% Stocks 20% Stocks 20% Stocks 20% Stocks 30% Stocks 30% Stocks 30% Stocks

Note that for interim goals with short time horizons (<5 years), asset allocation does not change much if at all for either objective risk capacity or subjective investor temperament.  Returns are unpredictable over so short a period, so it is in all cases sensible to have little or no exposure to stocks, to avoid potential downside volatility.  With diminished volatility, there is no need to vary for temperament.

An approach for the risk averse

Ideally, I would like you to understand and manage the emotions that arise over your investing journey.  To be comfortable with the idea that investing entails volatility along the way but delivers solid results over the long term, in stocks especially.  This puts you in a position to allow your money to work hardest for you, in the highest returning asset classes.  On the other hand, I advise you to be honest with yourself in assessing your own emotional make-up, including how you’ve behaved in past market declines and how you’re likely to react in future ones.  For setting out on a path that requires maintaining a measure of composure does more harm than good if down the road panic causes you to sell when markets get nasty.

So, there’s a tension here.  And it’s particularly relevant today.  The last 20 years have provided ample traumatic experiences, with jarring declines in financial markets from 2000-2002 and again in 2008.  Wariness is understandable.  Particularly for those of you who came of age around the year 2000 and thus may lack sufficient positive market experiences to balance out these bad ones.

If you find yourself in this boat, here’s an approach I can suggest.  Begin with a conservative mix of asset classes, with just a modest allocation to stocks, even if you have the time frame that would call for a robust allocation.  For example, if you are in your 20s or 30s—thus with 30 or 40 years until you retire and many years thereafter—begin with a mix of stocks that may be half or less than half the ideal mix.  Note that in the framework above, I limit stock exposure to 20-30% of the overall portfolio for someone in the “Low” category for volatility tolerance.  When stock market declines do come about, your overall portfolio will be more stable, and you can take heart in the fact that your exposure to the stock market is modest.

Over time, watch how your stock funds perform—observe the declines and the advances.  Practice not getting too despondent or too giddy during these periods, which may last many months.  Recognize how your stock portfolio climbs over time, with the advances outpacing the declines.

I hope this allows you to grow more comfortable.  After a full market cycle or two, reassess your investing temperament.  Re-take the Investor Temperament Questionnaire.  Ideally, you may find yourself in a position to move to a more objectively optimal mix of assets, including a more robust allocation to stock funds.