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3 Essential Rules for Successful Asset Allocation

Jeremy Chia

When it comes to asset allocation, there’s no one-size-fits-all solution. Asset allocation should depend on factors such as age, income, risk tolerance, financial needs and goals. However, there are some general rules that you can follow when deciding how to divide your stock portfolio. 

Rule #1: Money that you need in the next six months should be held in cash

Although all the rules I will list here are going to be important, this is perhaps the most important of all. The last thing you want is to be forced to liquidate your stocks during a market downturn and incur a loss on your investment.

As such, any money that you will need to spend over the next six months should be held in cash. In fact, I think it may be prudent to be a bit more conservative than that and have at least one year’s worth of expenses in cash. You can keep your cash in a savings account that may pay you some interest.

Rule #2: Money that you need over the mid-term should be held in safe, less volatile assets

You don’t want to dabble in volatile assets for the money you need in the next three to five years. 

This portion of your savings should be held in safe assets such as government or high-quality corporate bonds or fixed deposits.

In Singapore, there has been a host of corporate bond issues that have been sold to retail investors, such as the Singapore Airlines Ltd bond that was issued earlier this year. The advantage of bonds is that you can hold them to maturity, and you will not have to worry about fluctuations in the bond price. You can also choose bonds that have a maturity that suit your investment time-frame.

You should not be investing this portion of your portfolio in stocks as they may be quite volatile (even in a three to five year period, more on that below) and ideally your investment horizon for stocks should be longer than five years.

Rule #3: Money you don’t need for more than five years can (and should) be invested in stocks

The last bracket of money is that which you don’t need for more than five years. This money is the perfect candidate for shares.

Even if you are a retiree, a portion of your wealth should be invested for a long-term. That’s because the life expectancy of Singaporeans has increased substantially. Even a 65-year old retiree in 2018 is expected to live another 22 years.

Stocks have historically outperformed all asset classes over a long time frame. According to Jeremy Siegel’s book, Stocks for the Long Run, stocks beat bonds 71% of the time in rolling five-year periods, 80% of the time in rolling 10-year periods and 100% of the time in rolling 30-year periods.

The chart below also perfectly illustrates why long-term investing in stocks is a great option, even for “risk-averse” investors.

Source: Motley Fool Singapore article

The chart shows the odds of making losses in the Straits Times Index (SGX: ^STI) from 1 May 1992 to 12 January 2016 for different holding periods (dividends and inflation are not accounted for).

Although the chart shows that there is an about a fifty-fifty chance of making a loss over a day, and a relatively high chance of making losses over a year or even a five-year period, the odds of making a loss drops substantially if your holding period is 10 years or more. If you invested in the Straits Times Index over any 20-year period since inception, the odds of making a loss drops to zero.

That just goes to show that a so-called “risky asset” has very limited risk if held over the long-term. Coupled with its better track record of returns, stocks make the perfect investment for a long-term horizon.

The Foolish bottom line

Asset allocation is one of the first decisions to make when building a portfolio that suits your needs and goals; when you need the money essentially dictates where to invest it.

Money that you need in the near to mid-term should be held as cash and in safe assets, respectively. On the other hand, money that is not needed over the next five years is a great candidate for the stock market as shares, in general, tend to outperform other asset classes over a longer time frame.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned.

Motley Fool Singapore 2019