Asset Allocation Guide: Dealing with conflicting goals

Today we conclude our series on how best to make asset allocation decisions. It's an easy decision when the analysis of your ability, willingness and need to take risk leads to the same conclusion. For example, one can have a high ability and willingness to take risk but little need. In that case, the answer is simple: Because the marginal utility of additional wealth is likely low, the need to take risk should dominate the decision.

However, conflicts often get in the way, making the choices more difficult. Consider the following situation:

Philip is an extremely nervous investor. His willingness to take risk would probably produce an equity allocation approaching zero. He knows, however, that a very low equity allocation is apt to produce very little, if any, growth in the real value of his portfolio. This directly conflicts with his personal objective to retire within 10 to 15 years.

To attain this objective, Philip knows he must take more risk, so he chooses an equity allocation of at least 80 percent. The lower the equity allocation, the longer he would have to continue working. His willingness to take risk proved to be in direct conflict with his personal goals. For Philip, there was no correct answer to this conundrum. He would have to choose which of his objectives would have greater priority -- the need to sleep well or the desire for early retirement.

Ultimately, Philip decided his early retirement objective should take priority. He realized this decision was apt to produce those sleepless nights and that his ability and willingness to stay the course might be sorely tested.

Choosing the higher equity allocation (taking more risk) was the right choice for Philip, but it might not be the right choice for you. In general, I recommend choosing the lowest equity allocation derived from the three tests (ability, willingness and need) and then altering your goals. For example, if you find you have a higher need to take risk than your ability or willingness suggests, your plan should use the lower equity allocation recommended by the ability and willingness to take risks.

Otherwise, if the risks show up -- in the form of bear markets or negative events such as divorce or job loss -- the plan will fail and you may not be able to successfully adapt to the change in circumstances. The alternative is to lower your goal, save more now and/or plan on working longer.

Keep in mind that the more options one has, the more risk one can take. Having said that, before taking a higher level of risk, make sure you are truly willing to exercise those options. For instance, while it may be possible to move to an area that has a  lower cost of living, if your spouse doesn't want to leave the grandchildren, it won't happen.