Malkiel’s Rule 5: Match Your Asset Mix to Your Investment Personality: How do allocate assets.

Once you have started regular savings, you need to decide how to allocate your savings among the 4 investment categories noted in Basic Point 2 (cash, bond, stocks, real estate).

He starts off with a reminder: remember that risk and return are related.   Over the period 1926 to 2002:

• Cash investments averaged a 3 ½ % return but brought a risk of plus/minus 3%.
• Bonds averaged 5 ½ % return but brought a risk of plus/minus 9%.
• Stocks averaged a 10% return, but brought a risk of plus/minus 21%.

His chapter provides more detail than the table above on the performance the various investment options over time but in the end, he comes to this advice:

3 factors that affect asset allocation:

1)      Time horizon. The longer you have, the more of your money you can have in stocks (for greater earnings). The shorter your time horizon, the more that should be in cash and bonds.

Rule of thumb: your age should dictate the % of your retirement assets in bonds (and I think he intends to include cash). Example, if you are 25, can have 75% in stocks and 25% in bonds and cash. If you are 55 (as I am at this writing), he suggests you have 55% of retirement assets in bonds and other safe investments and no more than 45% in stocks.  An exception: money you are leaving to others that do not immediately need it.

2)      Capacity for risk – you may need to adjust the above general rule if you cannot afford short-term loss (i.e. decrease the % to stocks).

3)      Your temperament – similar to #2, you may need to adjust from the above general rules if you don’t have a temperament that can deal with short term losses. It is better to earn less in safe investments than to bail out of stocks when they take a plunge. “Sell down (stocks in your portfolio) to your sleeping point (where you can sleep at night).” He has a useful table on p 94 that related how much you can stand losing in a bad cycle vs what the percent you can have in stocks. It says, for example, if you cannot take losing more than 20% of your investment value in a bad cycle, you should have not more than 50% of your money in stocks.

Re-balance regularly

With changes in the values of various parts of your portfolio (e.g. stocks vs. bonds), your target mix can/will get out of balance with the target you established. When this occurs, re-allocate your investments to return to the right balance. He suggests rebalancing annually. To the extent possible, do this via new investment money (to reduce costs of moving money around (see Rule 7).

Next up:  Rule 6  – Reducing risk through diversification

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.