Portfolio Asset Allocation is a key element of investment planning, especially over the long term. Simply put, asset allocation is distributing your investments across various asset classes such as stocks, bonds, real estate and cash (or equivalent).
It is the single most powerful tactic at your disposal to ensure you make the most of your investments.
It is also the most underutilized one.
Why It’s Needed
We all have those friends – I know I do – who are terrible at investing their hard-earned money wisely. They’re smart and educated, with PhDs and Masters degrees in Engineering or Medical Sciences, but at a loss when it comes to investing. They buy investments that are expected to do well in the coming years and hold them until they stop doing well. They may also leave a lot lying around in cash as they’re too scared to buy when the “market is high” or are not sure where to invest. Over time, their portfolios are a set of randomly selected stocks, crypto currency, sector-specific bets and what not. If it were not for the mutual funds in their 401(k)s, they wouldn’t be diversified at all.
The right way is to invest in a diversified portfolio of low-cost investments and hold them for a long time. These should match your risk profile and long-term financial needs.
To achieve the objective of growing your wealth, you need to have a financial plan in place. What’s more important is that this plan is written down. This allows you to refer back to it in moments of weakness when you’re tempted to act on that hot tip your best bud just gave you.
Your Asset Allocation Should Change Over Time
The plan should take into account your risk tolerance, your anticipated needs and the stage of life you’re in currently e.g.
- The 20s: Young and just out of college, can afford to invest aggressively and make mistakes, and have enough time to recover from those mistakes
- The 30s: Getting married, starting a family, getting a mortgage, better idea of career and finances
- The 40s-50s: Peak earning years, college expenses, start thinking of retirement and subsequent planning
- The 60s / Senior years: Focus back on oneself, travel and other leisure activities
It is common for your Asset Allocation to be more aggressive when you’re younger and then start to skew more conservative as you get older. You have more to lose, and if you’ve followed your financial plan, likely don’t need to take on additional risk. That being said, asset allocation is unique to YOU and while there are some guiding principles, there is no right answer. You could be young and risk averse and your investment plan should reflect that.
Types of Asset Classes
These are the major asset classes that most people should consider.
Stocks have historically provided a higher return than bonds or cash alternatives. They are also riskier.
There are US stocks and International stocks, and can be further subdivided into:
- Large, Mid and Small capitalization
- Growth and Value
Less volatile than stocks, and also provide a lower rate of return. When interest rates rise, bond values tend to fall and vice versa. They do offer fixed payments at intervals so could be used to provide regular ongoing income. They include:
- Government bonds
- Municipal bonds
- Investment grade corporate bonds
- High-yield corporate bonds
- Mortgage-backed securities
Cash or equivalents:
Safest asset class, but also the lowest potential for growth. They’re also subject to inflation risk but are more liquid and instantly accessible. These are more appropriate for short-term use or for an emergency fund
Real estate is technically a sector, but it’s generally a not-inconsequential part of one’s net worth and hence is worth a separate mention. Properties generally appreciate in value over time but this is naturally very dependent on the geographical location. There are many strategies for building wealth using real estate but there are essentially only two broad types:
- Residential: Owner-occupied, Rentals etc
- Commercial: Offices, Retail, Industrial etc
So What Next?
You should study all asset classes and what they consist of so that you better understand how they’re different. You can start to understand correlations between the various classes and include ones that have less correlation than others. Diversification is not only across asset classes but also within a single asset class in terms of
- style (growth vs value)
- location (U.S. vs Developed markets vs. Emerging markets), and
- size (Larger established companies vs. smaller, growth-oriented ones).
Your objective should be to move away from a portfolio that consists of anticipated “winners“ and towards a well-diversified portfolio. The performance of your portfolio is determined more by the % of investments in each of the asset classes and less by the selection of specific investments within those asset classes.
No one can predict the future consistently over the long term. Having an asset allocation strategy that you stick to will ensure that your investments will still be there for you when you arrive.