To determine your maximum equity allocation, we start from the premise that, in the long-term, equities are the best performing asset class. Thus the objective is always to maximize equity allocation. However, we are also cognizant that you should not bite more than what you can chew. You simply do not want to be forced to sell at loss if you happen to be caught in a bear market or a correction. You need to have the luxury of time to wait until markets recover their losses, which they always do. Otherwise, paper losses become permanent losses.
We suggest two steps for determining your Maximum Equity Allocation:
The first step is to decide on a time horizon for dealing with volatility. This is the number of years that you think you need to wait for, for the market to recover. For most investors, we suggest five years (this is the default option in the questionnaire if you fail to answer this question). In other words, you do not invest any money that you might need in the next five years.
Now, why five years and not more or less? This is the historical median length of bear markets. In other words, most bear markets have historically cleared within a five-year time frame. You might argue: what if I am unlucky and the next bear market takes longer? The answer is: it can happen. So choosing the right time horizon really depends on your personal risk tolerance and thinking. It also depends on market valuation and where we are in the cycle. A mature bull market has more downside than a mature bear market. Also, a market trading at an average P/E of 20 times or 25 times has more downside than a market trading at a P/E of 10 times or 12 times.
For example, if you are in the middle of a bear market that you think is about to end, you might be comfortable with a five-year time horizon, unless you really are very risk averse and you prefer to maximize safety. If you are the risk-averse type, you would be more comfortable with a longer period, like seven years. You have the flexibility for such option. And, if you really want to be ultra conservative, you can even go for 10 years. Just be cognizant of two things: first, you can only contain risk in the case of a market crash but cannot totally eliminate it; second, if you go for seven or 10 years, your Maximum Equity Allocation will be lower and therefore your long-term returns will probably suffer.
The second step is to determine how much cash you need to spend over the next five years (assuming you chose five). For that, we provide you with a simple calculator to help you identify and aggregate all your income sources and expenses to determine your annual cash needs for the period, including an allowance for contingencies. This will determine your minimum cash needs and cash allocation. Your maximum equity allocation is the difference between total portfolio and minimum cash.
As an example, if Investor Joe is retiring on $1,000,000 and he needs to spend $60,000 each year, he should not invest more than $700,000 in equities. That will be 70% of his portfolio. If Investor John has a similar profile but is retiring on $2,000,000, he can allocate $1,700,000 to equities, i.e 85% of his portfolio.
This is a major improvement on standard asset allocation models in terms of grannularity. Here, you may have two people with the same degree of confidence in the market, the same risk tolerance profile and the same time horizon. Yet, their percentage of equity allocation would significantly differ, depending on how much money they have each.
Please keep in mind this does not mean that Joe will or should invest 70% in equities and John 85%. It only means that this is the maximum equity allocation that they should not exceed. The final allocation depends on other factors, such as how much should each of them invest in bonds or other asset classes.