Asset Allocation: How Should You Allocate Your Assets?
One of the most powerful engines driving the performance of any investment portfolio is asset allocation.
Asset allocation is important to a portfolio’s performance, but it is also a decision you’ll make.
With that being the case, it is much better to arrive at an asset allocation model via conscious decision about your investment objectives than simply by default.
What Is Asset Allocation and How Does it Work?
Asset allocation is the process of deciding which financial instruments (stocks, fixed income, cash, real estate) to invest in, how much risk to assume (conservative to very aggressive), and how much money to invest in each asset class.
While it may seem like a difficult concept, asset allocation resembles something we all have experienced in everyday life: going to a buffet.
Every customer at the buffet has the option to choose anything that is offered, from main entrees to side dishes and desserts.
Some items have more calories than others. The amount of calories people consume at the buffet may also be influenced by their age: Older diners typically have different eating habits than younger diners.
All these variables serve as an analogy that can help explain aspects of asset allocation strategies.
The main factors that should be considered when creating an asset allocation model are:
- The level of risk you can tolerate
- Your financial goal
- Your time horizon
- Whether you want to manage the process yourself or work with a financial professional
It is important to note that, over time, even a diversified portfolio has to be adjusted to market conditions and changes in your situation. This is especially important during periods of inflation, which can impact bond performance.
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Risk Tolerance
All investments involve risk. Deciding the level of risk you can accept and still feel comfortable with is one of the most personal decisions any investor must make when creating a portfolio.
Risk can never be completely avoided, but it can be managed through portfolio diversification.
The better risk-adjusted performing portfolios are built using combinations of different assets. One landmark study found that asset allocation policy is so important that it is responsible for determining more than 90% of a portfolio’s performance variability over time.
Financial Goal
Your overall approach to asset allocation should be in sync with your long-term investment goals. But you may also have a financial goal to reach in the short term.
For example, if your target date for retirement is many years in the future, you might accept higher risk in order to maximize your investment return. However, you may also need to save up for a down payment on some real estate. In that case, you may want to allocate some portion of your portfolio into the safety of cash equivalent investments to reach that financial goal.
Time Horizon
Your financial goal may dictate your overall investment strategy, but your time horizon also affects your approach to asset allocation.
That’s why it can be effective to consider asset allocation by age group.
If you’re a young person who’s investing for something far off in the future, such as retirement in 20 years, you should choose an asset allocation model that’s heavily weighted toward higher risk/reward investments like stocks. With a long time horizon, you can wait out some of the ups and downs of market cycles, and you are likely to need growth to keep your investments ahead of inflation.
In contrast, if you’re an older person and have near-term needs, you would be likely to select an investment strategy more geared toward stability and liquidity to make sure money is readily available when you need it. This would call for more conservative asset allocation.
DIY or Work with a Financial Professional
You can set your asset allocation yourself by buying separate securities or funds of different asset classes in a proportion that represents your target mix. You would then be responsible for making any necessary changes for tactical reasons or to rebalance your target date.
There are also professionally managed asset allocation funds that either maintain an allocation in line with a specified target or adjust the allocation over time in keeping with a particular goal. Target date funds, which are popular in 401(k) plans because they set an allocation based on when the participant plans to retire, are an example of the latter approach.
Both retirement plans like 401(k) programs and online brokers are likely to offer a choice between individual asset class products that require you to make asset allocation decisions and asset allocation funds that produce an asset allocation mix for you.
What Should Your Asset Allocation Be for Your Age?
Traditionally, financial professionals have used a formula that subtracts an investor’s age from 100 to determine their portfolio equity exposure. For example, a 40-year-old would have 60% of their portfolio invested in stocks. However, because people are living longer, this exposure to equities is being increased slightly to provide additional income over longer lifespans.
In practice, the basic idea behind a diversified portfolio is that one set of investments in an asset class will generally rise or fall at different times and rates during a market cycle.
Each asset class also has its own level of risk. Stocks are riskier than bonds. And since stocks are riskier, they also have historically delivered a higher return than bonds.
What Is a Conservative Portfolio?
The purpose of a conservative portfolio is to preserve capital and minimize the risk of loss.
The table shows how the typical portfolio for a conservative investor is over-weighted with fixed-income investments and money market funds, supplemented by large-cap stocks.
Conservative portfolios do not suffer the same price fluctuations as portfolios with riskier assets. Investors who have a short-term time horizon, want to preserve capital, are retired, or are approaching retirement often choose conservative portfolios.
Conservative Portfolio
What Is a Moderately Conservative Portfolio?
This type of asset allocation in retirement is a strategy designed for reduced risk even as it provides income.
The portfolio generates income through dividends and bond coupon payments while preserving capital. It can also include Treasury Insured Protection Notes (TIPs) that provide inflation protection.
Moderately Conservative Portfolio
What Is a Moderately Aggressive Portfolio?
Also known as a “balanced portfolio” with a near-equal mix of stocks and bonds, this portfolio has a balance between growth stocks and income-producing bonds and cash.
This type of portfolio is best suited for investors with moderate risk tolerance and a longer time horizon, typically greater than five years.
Moderately Aggressive Portfolio
What Is an Aggressive Portfolio?
This portfolio has greater exposure to equities, especially small-cap and international equities, which have higher risk exposures, to achieve greater growth and capital appreciation.
This portfolio is better suited to younger investors who are early in their working careers and can withstand any shorter-term losses that can be rebuilt over time.
Aggressive Portfolio
What Is a Very Aggressive Portfolio?
This portfolio is for investors with the longest time frame before retirement and the greatest appetite for risk.
It includes the highest percentage of equities, as well as more volatile instruments, such as cryptocurrencies, leveraged instruments, and exposure to more exotic asset classes via ETFs with exposure to emerging markets, small-cap stocks, and international bonds. The goal here is to generate the highest possible capital appreciation over time.
It is best suited for people with strong risk tolerances who can accept the proverbial risk of losing some of their money.
Very Aggressive Portfolio
Basics of Asset Allocation
Knowing the basics of asset allocation makes it much easier to choose how you want to allocate your investment funds.
1. Asset allocation strategies can be passive or active
You can choose a set-it-and-forget-it approach to asset allocation, where you maintain a set mix of different asset classes.
This is a passive asset allocation approach (also known as “passive investing”), where the only intervention needed is to rebalance the mix occasionally back to the target.
If you are shooting for risk/reward characteristics consistent with a specific blend of asset classes, a passive approach is most likely to produce those characteristics over time.
In many 401(k)s, this can be done via target-date funds (TDFs) that offer either a passive or active management approach. TDFs offer portfolios based on how many years you have until retirement. Portfolios are adjusted by a fund manager (or team of investment managers) over time to become less risky as you approach retirement.
In contrast, active asset allocation strategies involve making significant changes to the mix according to changing investment conditions.
If you think stocks are going to have a great year, you would move to a heavier allocation in stocks. If you thought the stock market was heading for a bear market, you would do the opposite and move into defensive stocks (utilities, consumer staples) of short-term bonds. Those active decisions would significantly alter the risk/reward characteristics of your portfolio.
2. Selecting asset classes
Stocks, bonds, and cash are the three basic asset classes commonly used, but there are a host of other choices, such as real estate, commodities, crypto-currencies, etc.
There are also subgroups of the three basic asset classes, such as government vs. corporate bonds, small company vs. large company stocks, and domestic vs. foreign securities.
Any group of securities that share similar characteristics and are influenced by factors distinct from other groups of securities is considered an asset class.
3. Historical returns of asset classes have limits
Asset allocation decisions are often based on historical risk/reward characteristics. Not only does history show past risk/reward characteristics for an individual asset class, but it also shows how different asset classes perform in relation to others.
A major benefit of owning different asset classes comes from non-covariance. This is the extent to which different asset classes rise or fall at different times. Having a part of your portfolio appreciating while other parts decline smooths out overall volatility.
Historical pricing shows what an asset class can deliver, but it should not always be considered a reliable road map to future performance. Risk and return characteristics can depart from historical norms over extended periods of time, and non-covariance between asset classes can change as well.
History is particularly unreliable when it comes to relatively new asset classes. Investors should be cautious of investments that have not been around for decades (such as cryptocurrencies) since they have not been tested over a full range of market conditions.
Planning Your Strategy
The asset allocation process is the first and most important step in creating a portfolio. The strategy you pick will be the main engine to help you reach your future financial goals.
Decide on your financial goal
The first step is to decide on your money goal. Is it short-term, e.g., saving money to buy a house or pay for your education, or is it long-term, e.g., investing money to help you save for retirement?
Decide whether to manage your investments yourself or hire a financial advisor
The next step is to decide whether to implement an asset allocation strategy yourself or seek the help of a financial professional.
Decide whether to do passive investing or active investing
Implementing your allocation strategy can be done via passive or active investment. A passive investment strategy is based on index funds that cover a broad number of individual stocks in a single package available through mutual funds or ETFs.
Passive strategies have lower fees and expenses than active strategies and those savings go right to your net investment return.Active strategies are done with a financial planner who makes mid-course corrections to your strategy in response to market conditions or as you get older. These require buying and selling individual funds that incur costs and detract from your total return.
Revisiting Your Strategy
Just as when you visit a buffet, the individual menu items on the buffet have to be replaced and replenished over time.
Your allocation strategy is the same. Portfolios are subject to ever-changing market conditions and gains or declines in the value of your holdings. You’re always getting closer to your target date, not to mention how your personal situation can change due to death, divorce, children, promotion, or job loss.
There are a number of portfolio rebalancing strategies.
One can be done on a constant basis, often when the value of the holdings gains or declines by 5%.
The rebalancing can also be done to take advantage of changing market conditions. When this happens, you would sell declining assets and buy assets that are increasing in value.
The last rebalancing strategy requires more active and discretionary management to take advantage of market conditions. However, active management rebalancing strategies are more expensive and expose the portfolio to the judgments (accurate or not) of the person managing the rebalancing.
All these factors can affect your risk tolerance. For these reasons, it is common to see portfolios become more conservative over time as retirement approaches. This can mean an increase in fixed-income exposure accompanied by a move to more conservative, large-cap, dividend-paying equities.
Asset allocation is the most important strategy that governs any portfolio regardless of how much is being invested. Take the time to do a critical self-assessment to determine how much market volatility you can tolerate without losing sleep at night. Then, determine how much you can regularly invest. Over time, choosing the right mix of investments should be the main engine in helping you achieve your financial goals while also adhering to the right diet of risk and reward.
