How to Determine the Right Asset Allocation: A Guide to Balancing Risk and Reward

One of the most common questions investors ask is, "How do I determine the right asset allocation?" Asset allocation is essential to building a balanced portfolio, and the key factors to consider are your ability, willingness, and need to take on risk. In this post, we’ll break down these three components to help you better understand how to structure your portfolio for long-term success. 

1. Ability to Take Risk 

Your ability to take risk is primarily determined by your time horizon—the longer it is, the more risk you can typically afford to take. Many investors mistakenly think of their time horizon as the period from today until retirement, but it’s actually the time from today until the end of your life expectancy. 

This means that most investors, particularly those who are still far from retirement, have a longer time horizon than they might realize. A longer time horizon gives stocks more time to recover from market downturns, which historically makes them a better-performing asset over periods of 10, 20, or more years. For example, if your time horizon is 20 years, stocks are about 95% likely to outperform cash or bonds. 

2. Willingness to Take Risk 

Your willingness to take risk is more about your emotional capacity to handle the ups and downs of the market. We call this the "stomach acid test." If your portfolio is too aggressive and causes you to lose sleep or consider abandoning your plan when the market performs poorly, this might be an indication that you need to reduce your allocation to riskier assets, like stocks. 

More aggressive portfolios with a higher allocation to stocks will naturally be more volatile. This means they will experience more fluctuations than a conservative portfolio. If volatility is causing significant anxiety, it might be time to shift to a more conservative allocation. 

3. Need to Take Risk 

The final factor is your need to take risk, which depends on your savings relative to your spending goals in retirement. If your savings are substantial compared to what you plan to spend, you may not need to take on as much risk. Conversely, if you have a higher withdrawal rate or more ambitious spending goals, you may need to take on more risk with a higher allocation to stocks. 

Those with lower spending targets relative to their savings can afford to invest more conservatively, while those with higher spending goals may need to seek out more aggressive investments to achieve their objectives. 

Bringing It All Together: Finding the Right Balance 

The ideal asset allocation for you is a balance of these three factors: your ability, willingness, and need to take risk. By carefully assessing each one, you can build a portfolio that aligns with your financial goals and your capacity to weather market volatility. Remember, the right allocation is not static—it may shift as your life circumstances, market conditions, and financial goals evolve. 

If you have any questions about determining the right asset allocation for your situation, feel free to reach out, and we’ll be happy to assist you in crafting a portfolio strategy that works for you. 

Squire Investment Management Company, LLC (“Squire”) is an investment adviser registered with the United States Securities & Exchange Commission. Registration as an investment adviser does not indicate any level of skill or training. This document was created for informational purposes only and serves as general market commentary; it does not constitute investment advice, nor is it intended as an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable; however, Squire cannot guarantee the accuracy of information obtained from third parties. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.