As fun as finding winning shares is (and trust us, it really is fun), your allocation to shares (equities) is only one slice in your total investing pie. Asset allocation basically comes down to how much you should have in cash, and how much in shares. The Fool’s three rules for asset allocation will help you slice up your portfolio into these important pieces.

Rule 1: If you need the money in the next one to five years, it should be in cash. Choose a term, fixed-deposit, or high-interest savings account.

You don’t want the deposit for your European holiday, or worse, your kid’s school fees to evaporate in a share-market crash.  Keep it in a term deposit or a high-interest savings account. As with any product, shop around for the best rates.  There, done.

Rule 2: Any money you don’t need within the next five years is a candidate for the stock market.

We are fans of the stock market. Over the long term, shares have consistently outperformed the returns on cash and most other forms of investment, the only possible exception being property.

Of course, in the short run, no one knows what shares will do. But make no mistake: Even if you’re in or near retirement, a portion of your money should be invested for the long term.  While the retirement age is 62, the average life expectancy of a Hongkonger today is 84 years.  So unless you’re a 95-year-old skydiver who drinks and smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should…

Rule 3: Always own stocks.

Over the long term, shares are the best way to ensure that your portfolio withstands inflation and your retirement spending.

In the US, according to Jeremy Siegel’s Stocks for the Long Run, since 1802 US stocks outperformed US bonds in 69% of rolling five-year investing periods (1802-1807, 1803-1808, etc.). The percentage of the time that shares wallop bonds only improves as you look over a longer horizon.

Holding Period Stocks Outperform Bonds
3 Year 67%
5 Year 69%
10 Year 80%
30 Year 99%

Data from Stocks for the Long Run, by Jeremy Siegel.

In the US at least, for holding periods of 17 years or more, shares have always beaten inflation, a claim bonds can’t make.

The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? That favourite term among financial gurus: your tolerance for risk.

Risk drives return

Most people base their investment strategies on the returns they want, but they have it the wrong way round. Instead, focus on managing risk, and accept the returns that go along with your tolerance for it. It’d be great if we could get wonderful returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we’ll lose money.

So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you’re retired, can you rely on other resources such as your MPF or kids, or would you have to go back to work or downsize your home (and how would you feel about that)?

Your answers to those questions will lead you to your risk tolerance. The lower your tolerance for portfolio ups and downs, the more cash you should hold.

As an extra aid in determining your mix of shares and cash, consider the following table, from William Bernstein’s The Intelligent Asset Allocator:

I can tolerate losing ___% of my portfolio
in the course of earning higher returns
Recommended % of portfolio
invested in shares
35% 80%
30% 70%
25% 60%
20% 50%
15% 40%
10% 30%
5% 20%
0% 10%

So, according to Bernstein, if you can’t stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in shares. Sounds like a very good guideline to us.

OK, you now know how much you should have in shares. But what kind of shares — large caps, small caps, value, growth, international? And how much?

Over in the US, we use these charts as a guideline for basic allocations, based on where you stand on your lifelong investing journey.

Action: Determine how much you should invest in shares. Just use Bernstein’s table above. And remember that our appetite for risk changes depending on current market and personal circumstances. So err on the conservative side if you’re taking this quiz during a bull market (and vice versa).