ASSET ALLOCATION

Asset allocation

What is asset allocation?

Asset allocation refers to the strategy of dividing your investments among different asset categories, such as stocks, bonds, real estate, cash, and cash alternatives. Asset allocation aims to control risk by diversifying an investment portfolio.

Deeper definition

The purpose of asset allocation is to maximize returns and minimize risk. While there are no guarantees that any particular mixture of investments will be more profitable or less risky than any other, a solid diversification strategy helps optimize a portfolio of investments.

Whereas asset allocation describes the proportion of a given portfolio held in different sorts of assets, diversifying and rebalancing comprise the act of allocating assets.

Investors diversify their portfolio by holding a portion in stocks and a portion in bonds, which helps balance risk. During market downturns, stocks suffer and bonds thrive; in a bull market, stocks appreciate and bonds lose value. Keeping a portion of the portfolio in cash is always a good option.

Rebalancing means changing the proportion of different assets in a portfolio. Asset allocations can fall out of alignment as investors change their outlook and the economy changes. Rebalancing tunes the allocation of assets in a portfolio to a more appropriate level of risk. Professional investors are constantly looking to rebalance their portfolios, while individuals rebalance less frequently.

Risk tolerance measures the degree of uncertainty an investor is willing to accept in exchange for greater or lesser future gains. More risk tolerant investors are willing to absorb more near-term losses for potentially greater returns in the future. Risk tolerance is also determined in part by how much you have to invest; a greater total amount of capital means an investor can absorb more losses over time.

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Asset allocation example

A conservative asset allocation would put 70 percent to 80 percent of available capital in bonds, 15 percent to 20 percent in stocks, and the remaining portion in cash or cash equivalents. Alternatively, an aggressive asset allocation would place up to 70 percent of available capital in equities, 20 percent to 25 percent in fixed income, and the balance in cash.

There is no simple formula that can find the right asset allocation for every individual. If there were, we certainly wouldn't be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation.

1. Risk vs. Return

The risk-return tradeoff is at the core of what asset allocation is all about. It's easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest potential—stocks and derivatives—isn't the answer.

 The crashes of 1929, 1981, 1987, and the more recent declines following the global financial crisis between 2007 to 2009 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. It's time to face the truth: Every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the relationship between risk and return.

Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you can't remain invested through the short-term fluctuations of a bear market, you should cut your exposure to equities.

2. Software and Planner Sheets

Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one old rule of thumb that some advisors use to determine the proportion a person should allocate to stocks is to subtract the person's age from 100. In other words, if you're 35, you should put 65% of your money into stocks and the remaining 35% into bonds, real estate, and cash. More recent advice has shifted to 110 or even 120 minus your age.

But standard worksheets sometimes don't take into account other important information such as whether or not you are a parent, retiree, or spouse. Other times, these worksheets are based on a set of simple questions that don't capture your financial goals.

Remember, financial institutions love to peg you into a standard plan not because it's best for you, but because it's easy for them. Rules of thumb and planner sheets can give people a rough guideline, but don't get boxed into what they tell you.

3. Know Your Goals

We all have goals. Whether you aspire to build a fat retirement fund, own a yacht or vacation home, pay for your child's education, or simply save for a new car, you should consider it in your asset-allocation plan. All these goals need to be considered when determining the right mix.

For example, if you plan to own a retirement condo on the beach in 20 years, you don't have to worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments. And as you approach retirement, you may want to shift to a higher proportion of fixed-income investments to equity holdings.

4. Time Is Your Best Friend

The U.S. Department of Labor has said that for every 10 years you delay saving for retirement—or some other long-term goal—you have to save three times as much each month to catch up. 

Having time not only allows you to take advantage of compounding and the time value of money, but it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A couple of bad years in the stock market will likely show up as nothing more than an insignificant blip 30 years from now.

5. Just Do It!

Once you determine the right mix of stocks, bonds, and other investments, it's time to implement it. The first step is to find out how your current portfolio breaks down.

It's fairly straightforward to see the percentage of assets in stocks versus bonds, but don't forget to categorize what type of stocks you own—small, mid, or large cap. You should also categorize your bonds according to their maturity—short, mid or long-term.

Mutual funds can be more problematic. Fund names don't always tell the entire story. You have to dig deeper in the prospectus to figure out where fund assets are invested.

The Bottom Line

There is no single solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don't have, don't worry. It's never too late to get started. It's also never too late to give your existing portfolio a face-lift. Asset allocation is not a one-time event, it's a life-long process of progression and fine-tuning.