Asset allocation: What You Need to Know
Asset allocation is one of the most important concepts in investing. It refers to how you divide your portfolio among different types of assets, such as stocks, bonds, and cash. Your asset allocation can have a significant impact on your investment performance, risk, and goals. In this blog post, you will learn what asset allocation is, why it matters, and how to choose the right one for you.
What is Asset Allocation?
Asset allocation is the process of deciding what percentage of your portfolio to invest in various asset classes. The three main asset classes are:
- Stocks: These are shares of ownership in a company. Stocks can offer high returns over the long term, but they also come with high volatility and risk. Stocks are generally considered aggressive or growth-oriented assets.
- Bonds: These are loans that you make to a government or a corporation. Bonds can provide steady income and lower volatility than stocks, but they also offer lower returns and are sensitive to interest rate changes. Bonds are typically considered conservative or income-oriented assets.
- Cash and cash equivalents: These are highly liquid and low-risk assets, such as savings accounts, money market accounts, certificates of deposit, treasury bills, and money market funds. Cash and cash equivalents can offer safety and stability, but they also have very low returns and can lose value due to inflation. Cash and cash equivalents are usually considered defensive or preservation-oriented assets.
Each asset class has different characteristics, such as risk, return, liquidity, diversification, and correlation.
Risk- is the possibility of losing money or not meeting your expected return.
Return- is the amount of money you earn or lose from your investment.
Liquidity- is the ease of converting your investment into cash without losing value.
Diversification- is the practice of spreading your investments across different asset classes, sectors, industries, countries, etc., to reduce risk and increase returns.
Correlation- is the degree to which two asset classes move in the same or opposite direction.
By allocating your portfolio among different asset classes, you can create a balance between risk and return that suits your personal preferences and goals. For example, if you are young, have a long time horizon, and can tolerate high risk, you might allocate more of your portfolio to stocks than bonds or cash. On the other hand, if you are older, have a short time horizon, and prefer low risk, you might allocate more of your portfolio to bonds or cash than stocks.
Why Does Asset Allocation Matter?
Asset allocation matters because it can affect your investment performance and outcome significantly. According to a famous study by Brinson et al. (1986), asset allocation accounted for 93.6% of the variation in portfolio returns over time, while security selection and market timing accounted for only 6.4%. This means that choosing the right mix of asset classes is more important than picking individual securities or timing the market.
Asset allocation can also help you achieve your financial goals more effectively. For example, if your goal is to save for retirement, you might want to allocate more of your portfolio to stocks when you are young and have a long time horizon. This way, you can take advantage of the higher returns and compounding effects of stocks over time. However, as you approach retirement age, you might want to allocate more of your portfolio to bonds or cash to preserve your capital and reduce volatility. This way, you can avoid large losses that could jeopardize your retirement income.
Asset allocation can also help you manage your emotions and behavior as an investor. Investing can be stressful and emotional, especially when markets are volatile or uncertain. By having a clear and consistent asset allocation strategy, you can avoid making impulsive or irrational decisions based on fear or greed. You can also stick to your long-term plan and avoid chasing performance or market trends.
How to Choose an Asset Allocation?
There is no one-size-fits-all formula for choosing an asset allocation. The best asset allocation for you depends on several factors, such as:
- Your goals: What are you investing for? How much money do you need and when do you need it? Your goals will determine your time horizon and required rate of return.
- Your risk tolerance: How much risk are you willing to take? How much volatility can you handle? Your risk tolerance will determine how much risk you need to take to achieve your goals.
- Your personal circumstances: What is your age, income, expenses, debt, savings, etc.? Your personal circumstances will affect how much money you have available to invest and how much flexibility you have in adjusting your portfolio.
Based on these factors, you can choose an asset allocation that matches your profile and preferences. For example:
- If you are young (e.g., 20s or 30s), have a long time horizon (e.g., 20+ years), have a high risk tolerance, and have a high income and low expenses, you might choose an aggressive asset allocation, such as 80% stocks, 15% bonds, and 5% cash. If you have the risk tolerance and timeline, 100% stocks can work well too.
- If you are middle-aged (e.g., 40s or 50s), have a medium time horizon (e.g., 10-20 years), have a moderate risk tolerance, and have a moderate income and expenses, you might choose a balanced asset allocation, such as 60% stocks, 30% bonds, and 10% cash.
- If you are old (e.g., 60s or 70s), have a short time horizon (e.g., less than 10 years), have a low risk tolerance, and have a low income and high expenses, you might choose a conservative asset allocation, such as 40% stocks, 40% bonds, and 20% cash.
Of course, these are just examples and not recommendations. There are a number of useful tools to help you determine your optimal asset allocation based on your specific situation and goals.
[Here is one… Download risk tolerance questionnaire]
How to Implement and Maintain Your Asset Allocation?
Once you have decided on your asset allocation, you need to implement it and maintain it over time. Here are some steps to follow:
- Choose your investment vehicles: You can invest in individual stocks or bonds, or you can use funds that hold a basket of securities, such as mutual funds, exchange-traded funds (ETFs), or index funds. Funds can offer more diversification, convenience, and lower costs than individual securities
- Rebalance your portfolio: Over time, your portfolio will drift from your desired asset allocation due to market movements and performance differences. For example, if stocks perform well and bonds perform poorly, your portfolio will become more stock-heavy than you intended. To restore your original asset allocation, you need to rebalance your portfolio periodically. This means selling some of the assets that have increased in value and buying some of the assets that have decreased in value. Rebalancing can help you maintain your risk-return profile and avoid overexposure to any asset class. You can rebalance your portfolio manually or automatically using a set schedule (e.g., quarterly or annually) or a set threshold (e.g., when an asset class deviates by more than 5% from its target weight).
- Review and adjust your portfolio: As your goals, risk tolerance, and personal circumstances change over time, so should your asset allocation. For example, as you get older or closer to your goal date, you might want to reduce your exposure to stocks and increase your exposure to bonds or cash. You should review your portfolio at least once a year and make any necessary adjustments to reflect your current situation and preferences.
Conclusion
Asset allocation is a crucial aspect of investing that can affect your investment performance, risk, and goals. By choosing the right mix of asset classes for your portfolio, you can create a balance between risk and return that suits your personal preferences and goals. You should also implement and maintain your asset allocation over time by choosing the appropriate investment vehicles, rebalancing your portfolio periodically, and reviewing and adjusting your portfolio as needed.