How Bumpy of a Ride Can You Handle? How to Determine Asset Allocation

Whew! We’re about halfway through the year, and what a year it has been. Many investors feel like they’ve gone from tubing down a calm river to white water rafting. It can be a lot of fun, but you have to know what you’re getting yourself into or you’ll fall out of the boat.

What you’re getting yourself into is called Asset Allocation in technical terms. It’s how you have your money invested— how much is in stocks, bonds, and other things. It matters a lot because different investments behave differently. Some are choppy Class 1 rapids and some are heart-stopping Class 4 rapids.

You may wonder why anyone would choose Class 4 rapids when they’re so scary. It’s because they get you to your destination faster. Typically, the investments with the greatest potential returns are the ones that move around the most. This volatility is called Risk in financial terms. Perhaps you have heard that stocks are riskier than bonds. That just means that their values fluctuate more.

Investors take on more risk (or volatility) in hopes of earning higher returns. Over the last hundred years or so, stocks have returned around 10% per year while bonds have earned about 5% per year. Those investors who took on more risk by investing in stocks were rewarded for it.

When choosing your investments, you have to consider what kind of returns you need. It may be tempting to keep your money in cash, where the value doesn’t change, but that’s actually dangerous. Because the value does change. Historically, inflation has averaged around 3% per year. That means the purchasing power of all the cash you have is decreasing in value by 3% per year.

When deciding how to invest your money, you also need to consider how big of rapids you can stomach—your Risk Tolerance. Think back to 2022. How did your investments make you feel? If you don’t know what I’m talking about, then psychologically, you have a high risk tolerance. That year was bad for investors. It was only the third year since they started tracking in 1926 that both stocks and bonds were down. If you were a nervous wreck in 2022, then you have a low psychological risk tolerance. You get seasick in white water.

Your emotional response is not the only factor in risk tolerance; your financial situation plays a big part, too. If you’re 30 years old and have 35 years before you’ll be using your retirement funds, you have a high risk tolerance. You can ride the ups and downs of the stock market because you have plenty of time for your accounts to recover after you go over a waterfall. If you’re retired and need that money to pay your air conditioning bill next month, then you have a lower risk tolerance. You can’t afford for your money to lose half its value.

Just because you’re retired doesn’t necessarily mean you have a low risk tolerance, though. If you can cover your living expenses with your Social Security checks and pension income, you may have a high risk tolerance for your investments. You can afford to have your money lose half its value because you don’t need it.

So what kind of water sports are you up for?

The Class 4 rapids of the stock market? The Class 1 rapids of bonds? The lazy river of cash? Likely, you’ll want a combination of those. Your exact combination, or Asset Allocation, should be determined thoughtfully, taking into account both your feelings and your financial situation.

Amy Artiga is a Certified Financial Planner (CFP), a Certified Kingdom Advisor™, and author of the clergy personal finance blog PastorsWallet.com. Send questions for Amy to benefits@nazarene.org.