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Asset Allocation Basics
The "Science" of Allocation
Asset allocation is not an exact science, nor is it a one-size-fits-all program. Forget the rules of thumb you hear, like your age should determine the percentage you should have in bonds. Some say you should subtract your age from 100 and the result is the percentage that you should have in equities. Don't both of these yield the same result? The makeup of your portfolio is purely personal--based on your risk tolerance level, the amount of your portfolio, the time horizon for the investment, and so on.
The Real Estate Dilemma
In determining the amount of your portfolio that should be allocated to bonds, first consider your real estate. Real estate is an illiquid investment and, therefore, very difficult to adjust for proper asset allocation. There is also a fair amount of risk inherent with real estate. After all, property values fluctuate and the previously mentioned illiquidity complicates the picture if you must liquidate quickly. During a buyers' market, you could be forced to sell at a substantially reduced price, which would only be exacerbated by your need to sell. In your case, you have $900,000 worth of real estate that comprises nearly 60 percent of your portfolio. So, the question becomes: How we are going to account for the real estate in the equation?
One Option
First, let's assume that you are very comfortable with your real estate investments and that you intend to keep the properties. Then we are left with allocating the balance of your portfolio--only 40 percent of the total. Here's where your risk tolerance comes into play. You are still working and may not need this money for a number of years, especially if you're also generating rental income. So, you could consider a relatively aggressive portfolio and maintain approximately 20 percent of your total in bonds. This would equate to over $320,000 in bonds. This would leave 20 percent of your portfolio for investment in equities such as stocks or stock funds.
No Magic Numbers
I'll stress there's no magic performed to arrive at these numbers. I made a lot of assumptions and reached a possible conclusion that might be acceptable to you. If it is too aggressive, then increase the amount you have in cash equivalents, bonds, and perhaps even real estate. Make sure to read my analysis of a second approach to accounting for real estate in asset allocation.
See What Jeff Says About:
• Many Ways to Cut the Pie
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