The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve? – Jack Bogle
Learn the basics of asset allocation and you can become a successful investor. Any expert will tell you that developing your asset allocation strategy, is the most important step to successful investing.
What is Asset Allocation?
Asset allocation is how you choose to divide your investment portfolio between asset classes such as stocks, bonds, and cash to maximize your chance of achieving your financial goals with the least amount of risk.
Asset Allocation vs. Diversification
Asset allocation and diversification are often confused with one another. Think of an investment portfolio split between two stocks and two bonds. If your goal was to have a portfolio allocated to 50% stocks and 50% bonds, you would technically have the right asset allocation. However, because you only have 2 stocks and 2 bonds, your portfolio wouldn’t be diversified.
Another way to look at asset allocation and diversification is through your diet. A general recommended diet consists of eating around 50% carbs, 30% fat, and 20% protein. You find that eating oatmeal for breakfast, a salad for lunch, and fish for dinner satisfies this diet. So you follow this meal plan day in and day out.
Technically, your diet would satisfy the allocation between carbs, fat, and protein. However, your sources of carbs, fat, and protein should be diversified.
The same can be said as investing. If you decide upon an allocation of 100% stocks, you shouldn’t own a portfolio of just one stock. You need a variety of stocks.
Why Is Asset Allocation Important?
A famous study known as “The Detriments to Portfolio Performance” published in 1986, found why the return of one fund can be so different from the return on another fund. Overall the study looked at 91 pension funds over a 10 year period and came to the following conclusion:
Only four factors determined the rate of return between the funds:
- Investment Policy or Asset Allocation
- Security Selection
- Market Timing
Out of those four, they determined that 93.6% of the fund’s performance was due to its investment policy. Factors such as individual security selection, market timing, and costs accounted for only 6.4% of the returns.
All About Asset Allocation – What Determines Allocation
There are three factors that determine your asset allocation:
- Risk Tolerance
- Current Financial Situation
How can you succeed, if you don’t define success? Your asset allocation plan needs to begin with defining success.
Use the acronym SMART, to set financial goals.
- Specific – Set your financial goals as specific as possible. You need an exact dollar amount and date.
- Measurable – How much do you need to save each month? For example, if you want to maximize your Roth IRA this year, you need to save $5,000 over the course of the year, or about $417 each month.
- Attainable – Your assumptions, such as rate of return and inflation, need to be based off of realistic data.
- Relevant – If you set a goal six months away, that goal must become even more important to you in six months, than it is today.
- Timely – A financial goal should always have a beginning or an end. If you don’t set an end, you’re never going to get to the end.
Time Horizon and Stocks
The chart below shows the 1,5,10, and 20 year returns, including dividends, for the S&P 500. I calculated 1,5,10, and 20 year returns for every 5th year, beginning in 1950.
Asset Allocation Strategy
|1 Year||5 Year||10 Year||20 Year|
As you can see the longer the time horizon the less deviation, or volatility, of returns.
If your goal was 1 year away and you put your portfolio in the S&P 500, who knows what your return could be. However, as you increase the time invested, the volatility of returns goes down.
Your risk tolerance is your capacity to watch your investments go down today, in exchange for a higher return in the future.
An aggressive investor with a higher risk tolerance favors investments that give the highest possible return in the future.
A conservative investor prefers to sleep better at night, in exchange for lower returns in the future.
Risk Tolerance and Asset Allocation
Search for “risk tolerance questionnaire” and Google shows 135,000 results.
Is it really this simple, to take a 10-minute risk tolerance questionnaire and determine your risk tolerance?
There are a few problems I see with risk tolerance questionnaires:
- Too Simple. There are too many variables to incorporate.
- Only measure downside and forget to measure what you will do if your investments gain 50% in one year. (Behavior risk)
- We tend overact to current market conditions. For example, in 2008 when the market was declining rapidly, everyone had a low risk tolerance. Then in 2009, when the market went up 50%, everyone had a high risk tolerance.
The only way to find out what you would do if the market declines is from experience. Experience, which you don’t have yet.
Therefore, instead of taking 15 minutes, to take a questionnaire, and decide your financial future. My philosophy towards determining your risk tolerance is to “educate, then allocate.” (Allocate as in your asset allocation)
Current Financial Situation
There is no one size fits all asset allocation for Gen Y.
If you were to just receive a $1,000,000 inheritance from your long-lost rich aunt, would your situation require the same allocation as your poor friends? I don’t believe so.
Luckily, 95% in Gen Y is in a very similar situation right now; first career, just beginning to save, might have some student’s loans, renting or just bought a house, etc…
As our generation gets older, things begin to change. The single serial-entrepreneur in his 30′s will require a different allocation then two married teachers, who have a pension plan.
There are more investment choices besides stocks, bonds, and cash, but these three investment classes are all you need to reach your financial goals.
Stocks have the greatest reward, but come with the greatest risk. If the goal of long-term investing is to earn you real, inflation adjusted, long-term returns for the future. Then, a large portion of your portfolio will need to be in stocks.
Since 1871 through 2009, stocks have returned 10.59% or 6.68% above inflation, if you include the dividends that stocks pay out. This is the highest rate of return among the three main types of asset classes.
The reward is great with stocks, but their volatility makes for an awful short-term investment. There have been individual years, when the stock market has declined almost 50%.
Therefore, stocks are best suited for longer-term investments and for those that can withstand the year-to-year fluctuations that the stock market brings.
Bonds offer a medium reward, for medium risk. Since its inception 1986, the Vanguard Total Bond Market Fund has returned 6.86% a year.
Generally, when the stock market goes down, bonds tend to go up. Therefore, investors with less tolerance for risk might want to have a portion of their portfolio in bonds.
When you hear the term cash, think of saving accounts, money market accounts, CD’s, etc… These are low-interest investment, which offers very little risk.
The biggest risk that comes with investing in cash instruments is inflation risk. It’s possible that inflation can outpace your returns, causing you to have less money then what you started with.
Rules of Thumb
I listed asset allocation rules of thumb below, to give you a general idea about where you should be.
Your Age in Bonds
This rule of thumb says that your age should determine your allocation to bonds. Therefore, if you were 25 years old, 75% of your portfolio would be in stocks and 25% would be in bonds.
Personally, I believe this to be a little conservative for younger investors. Having 25% of your portfolio in bonds, when retirement can be over 40 years away, is a lot of opportunity cost. However, if you have a very low risk tolerance, this allocation might give you the best chance of succeeding.
120 – Age
This rule of thumb states that you should have 120 minus your age in bonds. Therefore, a 25-year-old, would have a portfolio of 95% in stocks and 5% in bonds.
If you really wanted to simplify your retirement portfolio, this rule is a good one to follow. I would recommend this strategy for someone with an average risk tolerance.
Maximum tolerable Loss X 2 = Maximum Equity Allocation
This is my favorite asset allocation rule of thumb. What I love about this rule is that it works for non-retirement portfolios as well.
If you had a goal that was 10 years away, like saving for a down payment on a house, how much of your investment are you willing to lose?
If you could accept a 10% decrease in your portfolio, your allocation to stocks would be 20%.
If Your Goal Is Less Than 5 Years Away, Don’t Invest in Stocks
This is a rule of thumb for short-term investments such as saving for a down-payment on a house. It’s not for anyone approaching retirement.
All About Asset Allocation – Conclusion
There is no asset allocation strategy that is right for every goal, risk tolerance, and financial circumstances. This is why I believe you must educate yourself, before you allocate your investment.
The goal is to find the asset allocation that gives you the greatest chance of succeeding. Only you can find that balance between risk and reward.
If you’re looking to develop as asset allocation strategy, here is a good resource from the SEC.
If you have any questions, let me know in the comments.