Selecting which Vanguard asset allocation ETF to purchase can be intimidating – especially if you ask friends, family, or colleagues what they think you should do. You’ll probably not only receive conflicting recommendations, each one will be sure they’re right, even if it’s a much riskier and aggressive asset mix than you’d select on your own.

Easy for them to say; it’s not their money at risk. My advice on seeking advice is to ignore what your peers are doing with their money. This money is yours; you’re the one who should decide how much risk makes sense for you. Fortunately, I’ve got three rational determinants to help you figure this out: They are your willingness, ability and need to take on market risks in pursuit of market returns.

So how do you start to quantify these components of quality decision-making? By completing an investor questionnaire, of course. Vanguard Canada has provided a decent online form, which I’ve linked to in the model portfolios section of the Canadian Portfolio Manager blog. It includes 11 questions, to help you consider your personal risk profile, as well as your investment circumstances.

Before you proceed, let’s look at each component involved.

Your Ability To Take Risk

Your ability to take risk depends on your investment time horizon and the stability of your income (or human capital). If you have many years to invest and a stable income, you should be able to take more risk.

For example, if you’re 30 years from retirement, and/or a tenured professor with a pension, you have the ability to invest in an asset allocation ETF with a higher stock allocation (more risk). On the other hand, if you’re a few years from retirement, and/or working less-reliable freelance jobs, you may want to consider an asset allocation ETF with a higher bond allocation (less risk).

Although Vanguard’s questionnaire is a good starting point, it’s not without its issues. For example, the first few questions relate to when you’ll need your money back. If you indicate that you plan to withdraw your money in 2 years or less, but you answer the remaining questions as aggressively as possible, the suggested asset mix will be 50% stocks and 50% bonds. This strikes me as way too risky for an investment horizon of under 2 years.

As a general rule of thumb, you shouldn’t invest in any of these ETFs if you require the cash back in less than 5 years. I analyzed hypothetical Vanguard asset allocation ETF performance over the past 20 years ending June 2019, and here’s what I found:

  • The worst 1- and 2-year periods were negative for all five ETFs.
  • The worst 3-year period was negative for all ETFs except the Conservative Income ETF Portfolio (VCIP), which holds 80% in bonds; even still, VCIP only returned 1%.
  • The worst 4-year period was negative for all ETFs except VCIP and the Conservative ETF Portfolio (VCNS). But these only returned 2.2% and 0.2% respectively.

Looking further out:

  • If you need the cash in 5–9 years, VCIP or VCNS should be the only Vanguard asset allocation ETFs on your radar. Even the Balanced ETF Portfolio (VBAL), which allocates 60% to stocks, returned only 0.3% over its worst 9-year period.
  • If you won’t need the cash for 10–14 years, VBAL could be an appropriate choice, as even its worst 10-year return during this period was around 2%.
  • If you don’t need the cash for 15–19 years, you could look at a more aggressive ETF, like the Growth ETF Portfolio (VGRO).
  • If you’re investing for 20 years or more (and you are comfortable dialing up your portfolio risk to eleven), the All-Equity ETF Portfolio (VEQT) might be right up your alley.

Your Willingness To Take Risk

Now, just because you have the ability to take risk, doesn’t mean you’re willing to remain level-headed during a severe market downturn. Even if you know you have 20+ years before you require the funds, can you keep your cool when your ETF’s value plummets (which it most certainly will from time to time)?

There are five questions in Vanguard’s investor questionnaire that address this concern. But when I completed them to be as conservative as possible (while still indicating a high ability to take risk), the suggested asset mix was 60% stocks and 40% bonds. This is probably too aggressive if you have a low tolerance for staying put during stock market declines.

To guesstimate your willingness to take risk, I suggest imagining what you’d do if the stock allocation in your portfolio dropped by 50%. While any ETF investment could theoretically drop to $0.00, this should be a reasonable worst-case percentage decline to consider.

So, if you’re considering VGRO, with an 80% stock allocation, assume the fund’s total value could drop by 40% in a severe market downturn. Now take the dollar amount of your portfolio, and visualize it dropping by 40% immediately after investing the cash. If you have $10,000, it drops to $6,000. If you have a $100,000, it drops to $60,000. Would you truly be willing to ride out that roller coaster, or (more likely), would you feel like you’d just made a huge mistake?

Be honest – are those temporary setbacks going to completely freak you out? Go through the same process with other Vanguard asset allocation ETFs until you’ve identified one you can stomach. By going more conservative, you may leave some extra returns on the table over time. But in my opinion, that’s a fair trade-off for avoiding the incredibly expensive mistake of trying to flee to a more conservative ETF (or, worse, cash) in the middle of a market panic, when you’d be forced to sell your holdings at a deep loss.

For this reason, I believe your willingness to take risk should take priority over your ability to take risk.

Your Need To Take Risk

The final consideration – often forgotten in all the excitement – is how much risk you need to take. Could you meet all your financial goals by simply investing in guaranteed investment certificates? If so, you may not need to put your savings at higher risk by allocating any of it to stocks.

If you’re a young investor – and not offspring of the rich and famous – you can probably assume you do need to take some market risk, which means you can mostly ignore this component for now. Out of the three, it’s simply a given.

As you build a more substantial portfolio, you can work with a financial planner to determine whether you can afford to take less risk over time.

Your Investment Experience

Before I let you go complete your questionnaire, I’d like to reemphasize the relationship between your willingness and ability to take on risk – and how your willingness should probably be the one driving the bus – especially when you’re still gaining investment experience.

As a young investor, you may often hear that time is on your side, so you can go aggressive, with risky investments.

If we’re talking about ability to take on risk, this is true. But if you only have a modest amount to invest, think about how excruciating it will be when the stock markets head south on their periodic “vacations,” taking your seed money along for the ride. Until you’ve personally had the chance to ride out some up and down markets, I would suggest opting for a more conservative or balanced ETF, rather than a growth-oriented or 100% equity ETF.

There’s nothing wrong with starting off with a more conservative asset allocation ETF, even if you’re very young, have a long-term time horizon, and a stable income. I’ve yet to meet an investor who failed to meet their financial goals because they invested in a balanced asset allocation, rather than a more aggressive one. So, don’t feel like you need to fake a high risk tolerance to fit in. You can go with a more conservative or balanced asset allocation ETF to start, and use all your youthful energy to embark on a highly aggressive savings plan. This is likely to literally pay more dividends over the long term.

Keep in mind, if your portfolio size is modest, say $10,000, you’re not giving up much dollar return by investing in a more balanced portfolio. For example, a 60% stock/40% bond portfolio like VBAL is expected to return about 3.9% annually going forward. On the other hand, a 100% equity portfolio (like VEQT) is expected to return around 5.5% per year – or 1.6 percentage points more. On a $10,000 holding, this is only $160/year. Think of it as purchasing “sleep better at night” insurance, well worth the cost.

Let others call you chicken. As you gain more experience, you can always decide to sell your VBAL holdings and repurchase VGRO or VEQT. Besides, you’ll get the last laugh 30-some years from now when your nest egg is well-rounded.

Hopefully you’re now feeling more confident about choosing the right asset allocation ETF for you. Before you run off to place your trades, do a quick reality check on what returns you can expect from these Vanguard Asset Allocation ETFs. Spoiler alert: It’s not anywhere near 10%.