Asset Allocation Often Depends on How Long You Can Afford to Stay Invested

When working with a financial adviser, the Investment Policy Statement (IPS) provides an overarching direction for how your money is managed and what is expected of your adviser. The IPS provides a framework for the investment strategy you are trying to accomplish, while spelling out who you are as an investor by defining your risk tolerance and financial goals. The IPS is not simply created after one meeting, but it is developed over time with your adviser. However, your circumstances may change, such as a substantial increase in income or your tolerance for risk may change, which may affect your investment horizons.

When working with clients, one of the most important factors financial advisers consider is your time horizon, or the time you can afford to be invested before you need access to your money. Time should allow you to weather the volatility that is inherent with the stock market; however, time alone is no guarantee of higher returns or less risk. For most investors, the longer your time horizon, the higher your risk tolerance can be. 

Generally, those with at least a 10-year investment horizon should have exposure to equities. This is especially true for your retirement accounts, since you generally cannot touch this money until you retired. This long-term money should be invested in high-quality investments, such as individual high-quality Large-cap stocks across multiple sectors or mutual funds that invest in a similar manner. According to Ibbotson’s 2015 Annual Yearbook, the average annual return for Large-cap stocks since 1926 has been around 12 percent.

Mutual funds can provide instant diversification, allowing investors with smaller amounts of money to diversify among many stocks in a cost effective manner. Your adviser may charge you a fee for managing your portfolio, which should be specified in your IPS. This could be in addition to the management fees that are included in the cost of the mutual funds. If you are working with an adviser and you have between $200,000 and $300,000 in assets, you should consider investing in individual common stocks. With individual stocks, you and your adviser can control when you recognize capital gains or losses, ideally providing you better tax efficiency, all while avoiding a mutual fund management fee.

Depending on your risk tolerance, which should be outlined in your IPS, you may allocate a percentage of the long-term portion of your portfolio to Small- and Mid-cap stocks or International stocks. These can be riskier investments, but when combined into a well-diversified portfolio, their higher volatility should be balanced by a long time horizon and other investments that may be more stable. According to Ibbotson’s 2015 Annual Yearbook, the long-term average annual return for Small-cap stocks has been 16.7 percent since 1926.

You could also use mutual funds or exchange-traded funds for specialized investments, such as International or Small-Cap stocks, because the management fee is often worth the experience and knowledge provided by the fund’s professional management.

As all advisers should tell you, past performance is not indicative of future results. Investing is inherently risky. However, with guidance from experts and your expectations outlined in your Investment Policy Statement, you should have a good idea if you are on track to meet your financial goals. - mdjonline.com