Asset Allocation Guide: How much risk do you need?

The first two posts in our series on asset allocation focused on investors' ability and willingness to take risk. Today, we turn our attention to the third of our three tests, the need to take risk.

The need to take risk is determined by the rate of return required to achieve financial objectives. The greater the rate of return needed to achieve one's financial objective, the more risks with equities (and/or small and value stocks) one needs to take.

A critical part of the process is differentiating between real needs and desires.

These are very personal decisions, with no right answers. However, the fewer items in the needs column, the lower the need to take risk. Conversely, the more items in the needs column, the more risk one will have to take to meet those need.

Therefore, regarding your financial objective, carefully consider what economists call the marginal utility of wealth -- how much any potential incremental wealth is worth relative to the risk you must accept to achieve a greater expected return. While more money is always better than less, at some point most people achieve a lifestyle they're very comfortable with. At that point, taking on incremental risk to achieve a higher net worth no longer makes sense because the potential damage of an unexpected negative outcome far exceeds any benefit gained from incremental wealth.

Put another way, from the book "Investment Management": "The inconvenience of going from rich to poor is greater than most people can tolerate. Staying rich requires an entirely different approach from getting rich. It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much."

Each investor needs to decide at what level of wealth his unique utility-of-wealth curve starts flattening out and begins bending sharply to the right. Beyond this point there's little reason to take incremental risk to achieve a higher expected return. Many wealthy investors have experienced devastating losses that could easily have been avoided if they had the wisdom to know what author Joseph Heller knew, as this story Kurt Vonnegut told about Heller shows:

"Heller and I were at a party given by a billionaire on Shelter Island. I said, 'Joe, how does it make you feel to know that our host only yesterday may have made more money than your novel "Catch-22" has earned in its entire history?' Joe said, 'I've got something he can never have.' And I said, 'What on earth could that be, Joe?' And Joe said, 'The knowledge that I've got enough.'"

The lesson about knowing when enough is enough can be learned from the following incident. In March of 2003, I was in Rochester, Minn., for a seminar based on my book, "Rational Investing in Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make." During my visit, I met with a 71-year old couple with financial assets of $3 million. Three years earlier their portfolio was worth $13 million.

The only way they could have experienced that kind of loss was if they had held a portfolio that was almost all equities and heavily concentrated in U.S. large-cap growth stocks, especially technology stocks. They confirmed this. They told me they had been working with a financial advisor during this period -- demonstrating that while good advice doesn't have to be expensive, bad advice almost always costs you dearly.

I asked the couple if, instead of their portfolio falling almost 80 percent, doubling it to $26 million would have led to any meaningful change in the quality of their lives? Their response was a definitive no. I told them the experience of watching $13 million shrink to $3 million must have been very painful, and they probably had spent many sleepless nights. They agreed.

I then asked why they had taken the risks they did, knowing the potential benefit was not going to change their lives very much but a negative outcome like the one they experienced would be so painful. The wife turned to the husband and punched him, exclaiming, "I told you so!"

Some risks are not worth taking. Prudent investors don't take more risk than they have the ability, willingness or need to take. Think about it this way: If you've already won the game, why still play?

Deciding on the asset allocation that will give you the best chance of achieving your goal is complex. First, you have to estimate the future returns on the specific assets you have decided to include in your portfolio. Unfortunately, the past isn't necessarily a good guide. Today, financial economists are forecasting that U.S. stocks will provide a nominal return of about 6.5 percent. For international stocks that figure is perhaps 7.5 percent. If you invest a portion of your portfolio in small and value stocks, you also have to estimate returns for those asset classes.

Historically, small and large value stocks have outperformed large and growth stocks by about 2 percent a year, and small value stocks have outperformed by about 4 percent. However, the issue is muddied because not all small and value funds are the same -- the smaller and more "valuey" the stocks in a portfolio, the higher the expected return. For bonds, the best estimate of future returns is the current yield.

Let's assume you decide to invest the equity portion of your portfolio by putting 50 percent in a U.S. total stock market fund and the other 50 percent in a total international fund. That would have an expected return of 7 percent. Now, assume that you invest in bonds that have a yield of 3 percent. You can now calculate the expected return of the portfolio depending on how much you allocate to stocks and bonds.

If you need a 5 percent return to have a high probability of achieving your financial goals, you'll need to have 50 percent allocated to stocks. However, if you need a 4.6 percent return, you could allocate 40 percent to stocks. On the other hand, if you need 7 percent, you would have to be 100 percent allocated to stocks. Alternatively, you could have a lower equity allocation but allocate a portion of your stocks to the higher-expected-returning asset classes of small and value stocks.   

Our next post will address the question of what to do when conflicts between the ability, willingness and need to take risk arise. For example, what do you do when you have the ability and need to take risk, but not the willingness?

Editor's Note: Some material for this article was adapted from the author's book, "The Only Guide You’ll Ever Need to the Right Financial Plan."

You can try out CBS MoneyWatch's new online asset allocation calculator.