It is clear that there is a broad consensus about the appropriate mix of stocks, bonds, and cash for "typical" investors at different life cycle stages. But are you a "typical" investor for your age, or should your portfolio be different from the consensus portfolio?

There are at least three reasons why your portfolio may differ from that of the consensus:

• First, you may be more or less risk tolerant than most investors your age.

• Second, your unique circumstances, especially as they pertain to your non-financial assets and liabilities, may dictate a different portfolio management style.

• Third, today's stock and bond market prospects may suggest a different asset mix.

How do you know if you have an average risk tolerance? While an investor's risk tolerance is of critical concern, it is difficult to measure. Probably the best approach to this tricky issue is to examine downside risk, which indicates the amount a given mix could be expected to drop during a severe bear market. If the recommended asset mix entails too much risk, you should adopt a more conservative mix, reducing the recommended portfolio management stock allocation by 10 percentage points; if you believe you can tolerate more risk, you can increase the stock allocation by 10%.
The second factor affecting an individual or family's target asset mix involves its non-financial assets and liabilities. These include real assets such as the family home, other real estate, a family business, and prospects for inheritance (whether certain or very likely). It also includes liabilities like a mortgage and the future costs of college education. It may also include the individual or family's human capital (that is, future income). While there are an infinite number of potential unique circumstances that may affect one's target asset mix, here are the most common circumstances:

• Suppose you will eventually receive the assets in a trust that holds $300,000 of high-grade bonds. This bond exposure outside of your overall investment portfolio means that more, perhaps all, of your investment portfolio can be allocated to stocks.

• Suppose the family owns a risky business that is the main source of income for the family. The high risk of this asset may suggest less risk in the investment portfolio.

• Suppose you have the flexibility to choose how much and how long to work later in life. You can invest more of your money in stocks and other risky assets than if you have no such flexibility. Of course, if your future income is in doubt, you should not take on as much risk in the retirement portfolio.

The third factor that may cause you to stray from the consensus mix in your portfolio management plan concerns market prospects. Recall the unanimous disapproval of market timing, which calls for sharp swings in the asset mix based on short-term market prospects. However, the current state of investment knowledge is mixed on the question of whether one should make modest changes in their asset mix based on long-term market prospects. Theory and some empirical evidence suggests that we have a limited ability to predict whether, for example, stocks will do better or worse than average over the next three years. Nobel-laureate Paul Samuelson looked at the evidence on this issue and argues that it is sufficient to warrant changing your target weights plus or minus 10% at most. However, others would strongly argue that investors should stick with a fixed-weight strategy, with rebalancing at least annually as part of their overall portfolio management strategy.

Portfolio Management Summary

A careful study of recommended asset mixes from four prominent financial firms and eminent experts indicates that they share much of the same portfolio management advice: a fixed-weight strategy is an excellent one; avoid market timing; diversify across stocks and bonds; diversify within the stock portion of the portfolio; and, as you age, shorten the maturity of the fixed-income portion of the portfolio.

The recommendations also reflect a broad consensus about the appropriate mix of bonds, stocks, and cash for the "typical" individual during each stage of his life cycle. However, there are times when an individual will not reflect the "typical" profile, and may need to stray from the consensus. An individual's target asset mix could vary from the consensus mix due to: his risk tolerance and atypical non-financial assets and liabilities, including human capital. In addition, an investor may reasonably decide to let the actual mix vary modestly from his target mix due to market prospects over the longer term.
Most of the shared portfolio management advice is basic—it reflects common elements of a sound portfolio.

But then, most of what one needs to know about investing is basic. Here's a rundown of the major factors affecting asset allocation decisions, and how they may change over time.

Risk Tolerance & Asset Allocation

Risk refers to the volatility of your investment portfolio's value. The amount of risk you are willing to take on is an extremely important factor because investors who take on too much risk usually panic when confronted with unexpected losses and abandon their investment plans mid-stream at the worst possible time. While some people do become more risk averse as they get older, risk tolerance is not necessarily a function of age; a conservative investor will go through changes in asset allocation over his life cycle, as will an aggressive investor.

Return Needs & Asset Allocation

This refers to whether you need to emphasize growth or income in your investment portfolio. Most younger investors who are accumulating savings will want returns that tend to emphasize growth and higher total returns, which primarily are provided by emphasizing stocks in an asset allocation. Retirees who depend on their investment portfolio for part of their annual income will want returns that emphasize relatively higher and consistent annual payouts, such as those from bonds and dividend-paying stocks. Of course, many individuals may want their asset allocation to reflect a blending of the two—some current income, but also some growth.

Investment Time Horizon & Asset Allocation

Your time horizon starts when your investment portfolio is implemented and ends when you will need to take the money out. The length of time you will be invested in your portfolio is important because it can directly affect your ability to reduce risk. Longer time horizons allow you to take on greater risks in your asset allocation, with a greater total return potential, because some of that risk can be reduced by investing across different market environments. If your time horizon is short, you have greater liquidity needs—the ability to withdraw at any time with reasonable certainty of value. Volatile investments such as stocks lack liquidity and require a minimum five-year time horizon; shorter maturity bonds and money market funds are the most liquid.

Time horizons tend to vary over your life cycle. Younger investors who are only accumulating savings for retirement have long time horizons for their investment portfolio, and no real liquidity needs except for short-term emergencies. However, younger investors who are also saving for a specific event, such as the purchase of a house or a child's education, may have greater liquidity needs. Similarly, investors who are planning to retire, and those who are in retirement and living off of their investment portfolio income, have greater liquidity needs.

Next Topic Portfolio Management: Follow 10 personal financial axioms