Most investors know that a portfolio comprised of 100% stocks carries a great degree of risk, but may not be aware that a portfolio of 100% bonds is exposed to interest rate risk, credit risk, principal risk and purchasing power risk. Additionally, a portfolio of all real estate can also carry an enormous amount of risk due to its potential illiquidity, varying cash flows, dependency on borrowing costs, and fluctuation in value. You will need to assess how much risk you can tolerate.
If the recent volatility in the stock, bond and real estate markets due to the credit crunch has made you lose sleep, it may be time to revisit your overall asset allocation strategy. Determining an appropriate allocation for your assets centers on assessing your risk tolerance, time horizon, and need for income.
Determining how much income you will need from your portfolio is another critical factor. It is important to determine if your desired income stream is reasonable given the total amount of your investable assets. For example, if your lifestyle requires an income stream of $150,000 per year and your investable assets are $1.5 million, you will need a high rate of return. This may not be reasonable if you have very little tolerance for risk.
Finally, it is very important to understand when you will need income from your portfolio and for how long. Typically, retirees spend more in the first phase of retirement than in later years. However, it is critical to make allowances for future health issues or long-term care needs. The bottom line is that a careful assessment of these three interrelated factors is essential in helping determine an asset allocation strategy that meets your goals and doesn’t keep you up at night.
