Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most important in determining how well-behaved your portfolio returns will be.

It’s been said that investing is all about the balance between greed and fear. Many die-hard investors would agree but believe that instead of a balance between the two, there is only one right answer: greed. Fear, to them, is a weakness of those who lack courage and fortitude. Greed, they argue, pays off over the long term. If on average, US stocks provide a 10-12% return, why not invest everything in aggressive growth stocks and earn even more?

The problem with this approach is that in the last 65 years the S&P 500 has only had three years where the returns have been between 10% and 12%. They tend to either be up 30% or down 10%. It may average 10% but the markets are rarely that well-behaved. So for those counting on nice 10-12% percent returns of the S&P 500, the ride will be extremely bumpy making it difficult to achieve your projections.

How much of your portfolio should you allocate to stocks and how much to bonds?

Many advisors try to determine the right asset class mix by assessing client attitudes toward risk. Clients are often asked to complete a generic questionnaire which is supposed to assess their risk tolerance. Using the client’s reported risk tolerance, the advisor then develops the appropriate asset allocation. However, more often than not, the risk tolerance surveys end up describing the financial personality investors wished they had more than it describes how they should be invested.

Some advisors simply create portfolios by asking the question: “How much anguish and worry can my client endure?” Then, they create a portfolio which pushes their client to the limits of their endurance.

Basing your asset allocation on risk tolerance is not the best way to reach your financial goals. For example, assume you are trying to get to an appointment on time. You generally don’t ask about your “speed tolerance” and then drive as fast as you can tolerate. Driving at your fastest speed to your appointment is usually not the safest way to guarantee that you arrive at your appointment in one piece. Most likely, you drive somewhere under your speed tolerance and enjoy a smoother ride. And while you don’t drive at your fastest possible speed, neither do you drive five miles an hour because, most likely, you won’t reach your destination on time at that speed.

We use a different methodology. In determining the appropriate asset allocation, the important value is neither greed nor fear; the important value is reaching the client’s stated goals. The battle between greed and fear gives way to the larger task of doing what it takes to meet a client’s goals and reach their destination in one piece. This method of portfolio construction does not depend on an investor’s risk tolerance.

There are a handful of other tools advisors use to evaluate the suitability of an investment strategy to an individual client. Some advisors recommend the same portfolio allocation of 60% appreciating stocks and 40% stable bonds no matter what the client’s specific situation. This conservative allocation does balance volatility and return nicely. But while it may provide an interesting return, it is certainly is not tailored to meet a specific family’s financial goals.

Another traditional rule of thumb is to take 100 minus your age and to allocate that amount to appreciating stocks and put the remainder in stable fixed income investments. This rule would suggest that a 50 year old be invested half in stocks and half in bonds. As longevity has increased, however, this formula has been adjusted.

Today, more growth is required to help portfolios support increasing longevity and longer years spent in retirement. The rule of thumb used by many advisors is to invest 120 minus your age in appreciating stocks and the remainder in stable fixed income investments. Now, it is typical for a 70-year-old to have a portfolio of half stocks and half bonds.

While these age appropriate recommendations are not very sophisticated, they do provide an important rule: A couple’s investments should grow more conservative over time. Allowing your portfolio to grow more conservative may help you reach your financial goals.

Part of tailoring an asset allocation to a client’s specific needs is to first to determine their individual spending requirements. The percentage that can be put in appreciating stocks can be computed by determining the amount of a couple’s assets that will be spent in the next five to seven years. As an example, a couple at age 65 should limit their spending to 4.36% of their portfolio’s value. If they invest assets in stability sufficient to cover the next six years of spending they would want to invest 27% of their assets in stable fixed income investments. Since the remaining 73% of their assets have a time horizon of longer than six years they could be invested in appreciating stocks. As a couple spends down their portfolio, they withdraw a larger percentage each year and would want to put a greater percentage in fixed income to cover the next six years.

The mix of stability and appreciation can be further adjusted based on other specific situations. If a retired couple has a frugal lifestyle compared to their net worth, they will not need all of their assets during their retirement. In this case much of their portfolio is being managed for the next generation. Since the time horizon is longer, an even greater percentage can be invested for appreciation. For example, if a couple’s withdrawal rate is as low as 2% of their net worth then as little as 20% in stability would cover the next decade of withdrawals.

Even when creating a very aggressive portfolio, having some fixed income investments can actually boost returns. Stable investments provide some cash on the sidelines. Having cash to buy back into stocks after a market correction both boost as well as smooths your investment returns. Because of the effect of compounding, smoother returns produce better returns.

The analysis for optimizing the mix of stability and appreciation depends on market assumptions, but needless to say that neither an all stock nor all bond portfolio is optimal. Combining the expected returns and stability of various mixes with your specific financial goals is what produces a personalized investment policy statement.