By: Coleman Fox
When I bite into my grandmother’s Christmas cookies, I instantly remember why they bring on the holiday spirit. These delicious treats are a feature wherever relatives gather for the holidays. Like many families, mine has a recipe from our ancestors that has stood the test of time generation after generation.
While my grandmother claims the cookies’ secret ingredient is that they’re baked with love, there’s clearly more to it. Any good baker knows the importance of meticulously following the recipe if you want to get the desired results. If there isn’t enough flour, the cookies won’t have proper structure. Carefully measured sugar ensures just the right sweetness. Scrimp on the sour cream, and the cookies lose their unique taste.
Ingredients from Scratch
Just as a seasoned baker knows that each ingredient plays a crucial part in a cookie’s taste and appearance, an experienced financial planner understands that asset allocation requires the proper mix of elements to create an investment portfolio that reflects a client’s needs.
My beloved family recipe is probably different than yours, and each requires its own ingredients.
Proper asset allocation differs from person to person, too, just like taste buds do.
The main ingredients to consider when constructing an effective asset allocation are risk tolerance, age, and purpose of investing. These are common to all asset allocations, but the right mix is unique to each client.
Turn Up the Heat: Risk Tolerance
Risk tolerance is arguably the most critical aspect of asset allocation. It can be hard to quantify, though. Clients tend to take a subjective view and go with feelings over facts.
Financial planners understand this dilemma and have created risk questionnaires to inject some objectivity into an emotional subject. Over the years, these questionnaires have improved in their accuracy for measuring tolerance. If you are risk-averse, you may toss and turn at night, fretting over how much value your portfolio lost in a recent market downturn. If you can stomach more risk, you take comfort in knowing that despite volatility, the market historically trends upwards.
Asset allocation should reflect your investment personality. The risk-tolerant can carry more equities than bonds in their portfolio and trade higher risk for the advantage of potential increased earnings. Meanwhile, the risk-averse will tilt more towards bonds and fixed returns for a less volatile investment strategy.
Better with: Time
Your time horizon is a more straightforward ingredient than risk tolerance to conceptualize in asset allocation. The closer you get to your specified goal or needing cash, the less time you must weather market volatility for the sake of gain. That means your portfolio mix will shift away from equities and towards bonds. With the proper proportion of fixed income, you won’t have to sweat a market downturn close to your target date. If you have a long time horizon, you have more opportunities to recover from market swings and can trade risk for higher earnings.
Simmer Down to Your Investment “Why”
The final main ingredient in asset allocation is your purpose for investing. Your “why” combines with risk tolerance, time horizon, and specified goal brings your investment strategy into clear focus.
If you are investing for your grandchild, for example, the asset allocation should reflect the level of risk that goes with her time horizon. The allocation for producing retirement income that you don’t plan to tap for 30 years should look much different than your 10-year-old’s 529 college savings plan. There’s no one size fits all, even within the context of your own portfolio. Each purpose can drive a different investment outlook.
Family cookie recipes and investment portfolios are both a unique mix of essential ingredients. Poorly baked cookies are hard to enjoy. A poorly chosen asset allocation fails to reflect your personality and preferences, won’t meet your financial goals, and brings on unnecessary stress.
Variations in risk tolerance, time horizon, and purpose call for a customized approach to your investments. Reach out to the experts at FJY Financial. We take time and care to build a financial plan that matches your life goals.
Baking the perfect cookie takes care as well, so don’t rush…and sneak-eat some of that delicious dough while you’re at it!