Do You Feel Lucky? Portfolio Allocations & Risk

In a recent post, I talked about Diversification – the idea of allocating an investment portfolio over a variety of asset classes to reduce risk or, volatility.  Think circling the wagons to protect from attack from any direction.

There are other ways to reduce risk – some of which can be pretty sophisticated. But the simplest and most obvious strategy to reduce risk is to allocate a portion of one’s portfolio to safer asset classes such as Bonds. See my 3-part blog series on Fixed Income Investments.

Conventional wisdom tells us that the older one gets, the more bonds (lower volatility) one should have in their investment portfolio. If a market downturn occurs when you are 65, there is not a lot of time to recover.  To quote John Bogle, the legendary founder of Vanguard and father of low-cost “Index” funds, from an interview at the 2013 Morningstar Investment Conference, “Your fixed income position should have something to do with your age.” Makes sense… The older you get, the more concerned you become with the possibility of outlasting your money.

I like to use Monte Carlo simulations to help my dentist & orthodontist clients determine an appropriate degree of portfolio risk given their individual circumstances. It’s a great tool that gives you a range of possible outcomes given the data input. I ask for 3,000 answers, or, 3,000 possible futures that might show up, illustrating the odds of running out of money using different portfolio allocations. Someone might have a 15% chance of running out of money (I use age 95) if they are allocated 60% stocks and 40% bonds. Or, they could have a 50/50 shot of ending up with $5,000,000. After all, we asked for 3,000 answers… There are folks who have their own ideas about allocations which might go against the conventional wisdom or even the results of their Monte Carlo simulation.

Here is the discussion I have with my clients:  In addition to what the numbers tell us, I believe there are three questions that one must ask when deciding on portfolio allocations:

  1. Do you have the need for risk in your portfolio?
  2. Do you have the ability to have risk in your portfolio?
  3. Do you have the willingness to have risk in your portfolio?

Three simple questions that have different answers for everyone. Let’s say that Dr. Green is 60 years of age and has a $2,000,000 portfolio that is allocated 60/40. Based on his desired retirement age, lifestyle, charitable intentions, etc., he needs $3,000,000 to achieve his goals. He is pretty close given that he is still practicing dentistry and funding his retirement account like clockwork. Does he need more risk to reach $3,000,000? Probably not. Does he have the ability to have risk in his portfolio?  Being a dentist who does not have a mandatory retirement age, Dr. Green could work until he is 70 if need be, so, yes, he does have the ability to have risk in his portfolio.  That is the beauty of the dental profession.  On the other hand, Dr. Green has done well in his 60 years and attributes his solid financial footing to his conservative nature, avoiding the temptation to make wacky investments or overspend. In other words, he is not a risk taker, so his answer to question number 3 is no. He does not have the willingness to have more risk in his portfolio. These three questions help Dr. Green decide how to allocate his portfolio given all the other information available including the Monte Carlo results.

Dr. Grey has just seen her Monte Carlo simulation. At age 35 with a solid income, good saving habits, and a long career ahead of her, Dr. Grey has little need for risk in her portfolio. She has 25 – 30 years of saving ahead of her. However, Dr. Grey would like to leave a legacy behind; one that enables her to secure the future of her family and create a nice endowment for her dental school. Does she have the need for risk in her portfolio? In order to ensure her desired lifestyle in retirement, she does not. But, if she wants to leave $1,000,000 to the dental school, she does. Does Dr. Grey have the ability to have risk in her portfolio? With so many years ahead of her, she definitely does. Lastly, being a believer in the tenets of Modern Portfolio Theory, and confident in her Dental CPA/Wealth Advisor (me), she is quite willing to incorporate additional risk into her portfolio. The additional upside potential outweighs the downside and Dr. Grey sleeps well at night knowing that her plan is solid.

Clearly, the answers to these questions will be different for everyone, but the importance of asking them is clear – regardless of the answers.

Please email me if you would like to have this discussion.  I am happy to discuss your individual and practice goals in the hope I can help you bring all this into focus.

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