Creating and Implementing Your Investment Strategy – Part 2 – Determine Your Fixed Income Asset Allocation


In Part 1 of this series (see link below), I walked everyone through the first two steps in creating a personalized investment strategy.

  1. Determine the amount of cash liquidity you need for your emergency fund
  2. Forecast your future cash needs within 20 years in order to determine the minimum amount of fixed income Dollars you need to invest to meet your goals.

Creating and Implementing Your Investment Strategy – Part 1

In Part 2 of this series, we will walk through Steps 3-6 of the process in creating an investment strategy.

The end goal of this exercise is to make a final determination of the appropriate fixed income investment asset allocation.

Step 3 – Determine How Much Variability You Can Emotionally and Physically Tolerate

In investing, there are several certain, simple truths that you need to account for occurring at one time or another. One of these is the fact that your investments will decline and have very bad years from time to time.

The good news is that the “good times” in the market (when the stock market is increasing) usually persist eventually, enabling your investments to obtain a very good rate of return. However, in order to obtain these good rates of return, you must have the discipline to resist panicking and withdrawing your money from the market/equity exposure during declines.

In order to help you determine how much risk you are able to tolerate, we’ll need to analyze the table below (this table comes from Larry Swedroe’s book The Only Guide to a Winning Investment Strategy You’ll Ever Need).

The table matches a worst case investment decline (loss) that can be possibly occur in a year, given a certain % fixed income asset allocation. I also included what the % decline would indicate in real Dollars if you were to have $100,000 in total assets invested.

Imagine in your head what you would do if you were to lose X Dollars in a year. Would you sell all your equity holdings? Would you buy more? Would you hold out until the market recovered?

Be honest with yourself. You are only hurting yourself if you answer incorrectly.

Once you have thought about it for a few minutes, record the minimum fixed income exposure level that you decided on, based on the maximum tolerable loss you can physically and emotionally tolerate within any given year.

Step 4 – Compare Your Results from Step 2 and Step 3

Next, take the minimum fixed equity % exposure level calculated in Step 2 (based on your forecasted future cash needs – don’t worry to include your emergency fund needs) and compare it with the exposure level you calculated in Step 3.

Take the higher, more conservative fixed income exposure/asset allocation level of the two that you calculated. Proceed to Step 5 below.

Step 5 – Determine How Much Risk You Need To Take On to Meet Your Investment Objectives

The final step in determining your overall equity and fixed income asset allocation percentages is to consider how much money you need/want to have later in life from investing. For me, this decision more specifically means how much money I will need to have to live the lifestyle I want during retirement.

To determine this, click on the link below to see my previous post on calculating how much money you need for retirement.

How Much Do You Need For Retirement?

In the retirement calculator in the post above, the place where determining how much risk you need take on relates to the “Assumed Annual Return” field.

By principle of efficient markets, the only way to increase this assumed annual return is to increase risk. And, the only way to increase risk is to increase your exposure to equity via your asset allocation percentages.

The table below gives approximate equity allocation % exposure levels corresponding to different rates of return required to meet your financial goals.

Using the retirement calculator above and the table below, record your target equity allocation %. To get the target fixed income % allocation, take 1- target equity allocation %.

Step 6 – Finalize Your Overall Asset Allocation Targets

Finally, compare the result from Step 5 (how much risk/equity you need) with the result from Step 4 (how much security/fixed income you need).

How do the levels compare?

As a general rule of thumb, you should take the highest fixed income asset allocation result that is obtained. This will help you have less stress in life. If, however, you find that your result from Step 5 tells you that you need to take much more risk in order to meet your goals, I would start analyzing ways to either 1) cut current spending and save more or 2) plan to live a simpler life style in the future.

To read Part 3 of this series, click on the link below.

Creating and Implementing Your Investment Strategy – Part 3