Embarking on and sticking to your investment journey requires a solid understanding of financial principles and an appreciation for the emotional roller coaster that comes with it. Asset allocation, a crucial component of investing, is about striking the right balance between risk and reward to achieve your financial goals.
As you consider different allocations, it’s essential to recognise the emotional implications of your choices, allowing you to make informed decisions that align with your unique risk tolerance and personal well-being.
Financial planning has traditionally focussed on the numbers, often neglecting the emotional aspects of investing. This leaves many of us unprepared for the roller coaster ride that can come with aggressive allocations, such as the 70/30 (eg 70% stocks and 30% bonds) approach. Understanding the emotional side of asset allocation can help us make more informed decisions and avoid painful financial setbacks.
The 70/30 portfolio promises higher returns but also comes with the risk of significant losses. Investors who can accept the occasional tumble down an 18-step staircase (metaphorically speaking) may find this allocation suitable. On the other hand, those who prefer stability and insulation from worst-case scenarios might choose a more conservative 30/70 (eg 30% stocks and 70% bonds) allocation.
Regardless of strategy or numbers, we need to work together to comprehend the emotional impact of your chosen allocation before committing to it. Investors who cannot handle significant market swings may need to adjust their expectations and lifestyle accordingly. It’s essential to remember that there’s no guarantee that a 70/30 portfolio will outperform a 30/70 allocation – it all depends on timing and market conditions.
A critical issue in setting expectations is the misuse of the term “average.” When we’re told that the S&P 500 has averaged 11% for the past 20 years, we may assume this means we will see consistent returns close to that figure. In reality, actual returns deviate significantly from the average, leading to either excitement or panic and poor decision-making.
Emphasising the concept of standard deviation, or the market’s roller coaster-like fluctuations, can help us understand the inherent risks of investing.
When planning and working with our investments, we need to focus more on the emotional context of asset allocation. We can make better-informed, real-world choices by being emotionally forthcoming about the potential ups and downs of different asset allocations – enabling us to invest with heart and mind.
When framed in emotional terms rather than mathematical ones, people may choose more conservative allocations that better suit their risk tolerance and emotional well-being. After all, reaching financial goals is much more enjoyable when the journey isn’t filled with anxiety and stress!