Determining factors in asset allocation

Dr. Paul Kaplan reviews some of the main items to consider, such as age, lifestyle and portfolio size.

Paul Kaplan 22 August, 2012 | 1:00PM Christian Charest
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Christian Charest: I'm here with Dr. Paul Kaplan, Morningstar Canada's Director of Research and our resident expert on all things having to do with asset allocation. Paul, thank you for being here. Last time we spoke you explained to us the difference between risk tolerance and risk capacity, the latter being one of the essential elements in determining asset allocation. Today, I'd like to talk about some of the other points that investors and their advisors need to consider when trying to come up with the right allocation between stocks, bonds, and other asset types. We're going to start with where a person is in their life cycle, which I'm assuming is one of the big criteria.

Paul Kaplan: That's right. Where you are in your life cycle is a major criterion in determining how you should do your asset allocation as well simply allocating among all your financial resources broadly. When you are young and you have great deal of earnings capacity still ahead of you, you can afford to take a lot of risk; you can afford to put some – as you are building that nest egg to put some of it at risk, because you do have that time that eventually that kind of risk taking could payoff. However, as you approach retirement you have to be much more careful, because once you've lost your earnings capacity you now really have to focus on how to manage that nest egg and another factor would be how big is that nest egg? Is that nest egg big enough to not only taking yourself but perhaps the next generation, you want to leave something behind, or do you have a very limited resources and you really need to focus on taking care of yourself.

Christian Charest: So, the lifestyle that you want to lead when you're at retirement also ties into all of this – ties into how much you want to have left at the end of your life, how you much you want to leave behind, how much you want to be spending. And you mentioned how much you want to withdraw while you are in retirement?

Paul Kaplan: That's right. These all need to tie-in together and how much you want to withdraw, that's likely to vary over the course of your retirement. So, for example, when you’re at beginning of your retirement maybe you’re still in very vigorous health and you want to take that opportunity to do things that you've always wanted to do and now you finally have the time to do. Then there may be a period where you reduce your spending level, and then you may also run into some health issues at the end of your life, which would again increase your needs.

Christian Charest: This all ties into once again, how much risk you are able to take throughout all these stages of your life. As I said, we talked about the concept of risk capacity in our previous video and our viewers can click on a link to that video, which is right under the video player. Any final thoughts?

Paul Kaplan: Yes. I'd like to first of all continue on that thought of risk capacity, because it's very important that if you do have very limited means, you also have very limited risk capacity. And one of the temptations I think it's important for people to avoid is to say - Oh, I have limited means, I'm about to retire, let me just go into some risky investment and sort of just hope that it pays off. Well, the fact is it may not pay off, in which case you are going to have a more serious problem, more than before you started.

Secondly, is to just always remember that doing asset allocation is a very individualized thing and that there is no one size fits all for all investors. You really do have to look at where you are in your life cycle, what are your needs, what are your circumstances and really take all that into account and determine your capacity for risk as well as your tolerance for risk and really take all those elements together in determining, both, how much you should plan on withdrawing from your portfolio as well as how you should be investing it via asset allocation while you are in your retirement years.

Christian Charest: Thank you very much, Paul.

Paul Kaplan: Thank you.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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