In a world dominated by technology and shiny things, it’s easy to think that investing in a Tesla, Netflix, or Amazon is the name of the game . All you need to do is find one or a few stocks on an online platform that will grow exponentially, and you’ll become suddenly wealthier than Taylor Swift, Bill Gates, and Julio Iglesias combined. Diversification – who needs that? It’s for weak-minded suckers. An act of self-sabotage. Sound right to you? Well, it’s not. It’s utter garbage.
The truth is that for the past few decades, academics have shown that the risk and return of a portfolio isn’t determined by what stocks you pick. Instead, it’s determined by how you spread your assets among shares, bonds, and cash – what finance folks call “asset allocation”. 80-90% of a portfolio’s return can be explained by an investor’s asset allocation, so it’s one of the important financial decisions you’ll ever make.
Let’s take a how at you can find an asset allocation that suits via an old metaphor used in astronomy – the Goldilocks Zone.
Introducing the Goldilocks Zone Metaphor
In astronomy (not to be confused with astrology) the Goldilocks Zone is a term used to describe the orbital region around a star in which an Earth-like planet can possess liquid water and possibly support life. Essentially, the Goldilocks Zone is an area where a planet is neither too close to the home star for water to boil away nor too far for water to be frozen. It’s a zone that’s ‘just right’ – like the last bowl of porridge Goldilocks tasted before she fell asleep and was caught breaking and entering by the unfortunate Bear family.
The Goldilocks Zone used in astronomy is a brilliant metaphor for getting the right asset allocation in personal financial planning. Investors, just like astronomers on the hunt for Earth-like planets, are in search of a particular ‘requirement’ – more specifically, an asset allocation that fits their goals, timeframe, and risk profile. Thankfully, Kiwis don’t need to be a physicist like Kip Thorne, Neil deGrasse Tyson, or Brian Cox when it comes to investing. You can have the IQ of “Iron” Mike Tyson as opposed to Neil deGrasse Tyson and still be a successful investor. And if you’ve ever seen videos of Mike Tyson at press conferences when he was in his prime in the 80s and early 90s, that’s really saying something.
To find your Goldilocks Zone or right asset allocation, there are three things you need to sort out:
- Your objectives – what you want to achieve
- Your investment timeframe
- Your risk profile
If you have a clear goal, it’s much easier to know what your asset allocation should be, grade the performance of your investments, keep focussed on who you are, and celebrate success. Here are a few examples of clear goals:
- To live on $40,000 pa when I reach retirement in 10 years at age 65.
- To help provide a deposit on a house for my granddaughter, who is 5 years old, when she turns 25.
- To achieve a return of 8% pa over the next 10 years.
Conversely, it’s important to avoid fluffy or immeasurable goals. The trouble with such goals is that they’re either always achieved or are destined to create disappointment. Here are a couple of great examples:
- To save for a rainy day.
- To become mega-rich so I can retire by age 35.
The above may seem politically incorrect in an age where you can’t say anything critical. However, I think it needs to be said. Just to be clear, there are three reasons why it’s important to have clear and realistic goals.
Your Investment Timeframe
The length of your investment timeframe is a big consideration for your asset allocation. As a general rule of thumb, the longer an investor’s timeframe, the more they can comfortably invest in growth assets such as US shares and property. The short-term fluctuations that we see in share markets can be smoothed by taking a long-term view. This is shown in the following graphic. As we can see, the S&P500 fell 38% in 2008 as a result of the sub-prime disaster. However, it climbed 169% from the start of 2009 to the end of 2018. Similarly, the NASDAQ fell 68% from the start of 2000 to the end of 2002 owing to the tech wreck, 9/11, and the 2001 recession. However, it climbed 118% from the start of 2003 to the end of 2012.
Your Risk Profile
What’s a risk profile? It’s basically how much pain you can take when investing is normally expressed on a continuum from low-risk/low-return to high-risk/high-return. Low-return/low-risk investors typically invest much more in cash and bonds, whereas high-risk/high-return investors mainly invest in shares and properties. For the sake of simplicity, here’s a diagram (illustrative only) showing a risk profile continuum.
So how do you find out your risk profile? This is where things get really interesting. An experienced investor should know what their risk tolerance because they’ve been through the ups and downs of markets over many years. For investors who are new, that’s where things can get tricky. For those of you with KiwiSaver, chances are you have completed a questionnaire that basically assigned you to some category like aggressive or conservative with some explanation afterwards – that’s one simple approach to defining your risk profile. Similarly, Sorted has developed an investor kickstart tool. This is like the KiwiSaver risk profiling questionnaires – it asks you nine questions, then categorises you from defensive to aggressive.
These are pragmatic tools, but not perfect ones – more of an art than a science, since they try to quantify something that’s inherently subjective. They may also ask questions that the respondent isn’t overly familiar with. Similarly, such questionnaires don’t say anything about your risk capacity, which is a different thing to your risk tolerance. Your risk tolerance is about your emotions and general attitude to risk. Your risk capacity is about how much risk you need to take.
Finding the right asset allocation is absolutely essential in planning for your financial future and making the most of the new age that digital investing platforms have to offer. As discussed here, finding your “Goldilocks Zone” or asset allocation doesn’t have to be uber complex. If you’re unsure what your asset allocation should be, it’s recommended that you seek advice from a qualified financial adviser.
The above is my opinion. It is not intended to act as personal financial advice. It does not take into you account your financial objectives, situation and needs. It is strongly recommended you seek financial advice from an Authorised Financial Adviser before you make a decision.