Have you ever heard of asset allocation?
Maybe an advisor started talking about investment strategies, mentioned “asset allocation,” and you nodded along not knowing what he was talking about. Sound familiar?
It can seem overwhelming learning all the investment mumbo-jumbo.
What is asset allocation?
Let’s say you are moving across the country. You and two friends will be packing everything up and driving there. One if you is known to be both fast (so will arrive first) and a bit of a crazy driver, another obeys traffic laws and has a reliable vehicle, and the last drives an armored truck but has to make a bunch of stops so will be the last to arrive.
How do you decide who hauls what?
That’s asset allocation.
Just as you would pack those cars based on your timeline and risk tolerance – allocating your belongings to each car – that is how you can think of portfolio allocation.
It’s putting your money to work in the best possible way for your given circumstances.
But in personal finance, when people talk about asset allocation, it’s in regards to investments and how much you should put into each asset class.
Okay. So, what are asset classes?
They are large categories of ‘stuff’ to invest your money in. What are these categories? Well, there are basically four of them: equities, fixed income, cash and cash equivalents, and real estate and commodities.
First up are equities. These are stocks or shares of companies you can buy. If a company grows and does well and/or pays a dividend, you make money. If the company does poorly, you lose money.
Long term, equities do well because there is higher risk involved, which means there is usually a larger reward. They are also the most volatile in the short term. Remember the market crashes of 2008 and 2000 (and others)? That was primarily equities falling in value.
On the other hand, when “the market” is doing well, that is also usually attributed to equities.
Bonds are the typical fixed income product you hear about.
Bonds are debt where you lend your money to a company or government for a period, and they pay you interest.
Unlike the higher risk associated with equities, bonds are a safer, less risky investment that provides a steady income through regular fixed payments (thus the term ‘fixed income’).
Normally, an individual investor won’t buy an individual bond, but rather invest in a bond fund.
Here, cash and cash equivalents are what they sound like. It’s the money in your savings accounts, money market funds, U.S. Treasuries, and in CDs (certificates of deposit).
This is the safest, or least risky, asset class because it would be unlikely to lose money. However, the interest earned on cash is low and in some cases may not keep up with inflation.
Real Estate & Commodities
This last asset class is a bit of a catch-all. Often you’ll see real estate and commodities (like precious metals) lumped together here, though increasingly you’ll find Bitcoin and similar products in this asset class as well.
This class tends to be a bit more risky, depending on the investments and is sometimes confusing. There are many portfolios that ignore this as a separate asset class and instead rely on mutual funds to incorporate a small percentage of real estate, commodities and other alternative investments.
If you start reading more about asset classes, these four major classes can break down further. You can make it as detailed and complicated as you want. You can divide it up by domestic vs international, Europe vs Asia, market cap (company size), industry, etc.
Choosing your asset allocation
As you set up your investments, you’ll want to figure out your asset allocation. This is dependent on your needs and risk tolerance.
Let’s say you need a vehicle or a down payment on a house within the next few (under 5) years. That’s money you won’t want to be tied up in higher risk investments but would want in cash or cash equivalents. You’ll need this money soon.
If there is money you don’t need for several years (10 or more), then time is on your side with equities and other higher risk investments. In fact, if you are looking 30+ years out, you may want very little cash or bonds in your portfolio.
With higher risk investments, time tends to work in your favor for smoothing out any bumps in the road (market fluctuations).
As you get closer to retirement, most people want to take fewer risks and will then start investing in bonds and putting more in cash.
And then you’ll want to think about your needs in retirement. How long do you think you may live? Chances are you’ll still need investments working for you for a few decades yet, so going all cash and bonds may not be the optimal solution at retirement.
Do you bite your nails or go and sell off a bunch of your stocks when the market dips? That would indicate you are risk-averse and probably want a more conservative (less risky) portfolio.
On the other hand, if you say “eh, whatever”, then a more aggressive portfolio may suit you. Even more so if your reaction is “woohoo! It’s on sale! Let’s buy more!”
Of course, if you have your investments diversified over different sectors and types of investments, it helps lower the overall risk of your portfolio and smooths out the fluctuations.
Worried about picking investments? Fortunately, ETFs and mutual funds offer diversification and allow you to invest in many companies in an asset class all at once.
How important is asset allocation?
The returns in your portfolio along with the volatility can mostly be traced back to your asset allocation.
If you want to try to get high returns, you need to be able to stomach higher volatility (a bumpy ride) and be investing for the long term.
If you need your money sooner and would rather not risk losing much money your portfolio in the short term, your allocation should have more low-risk assets.
Think back to the crash of 2008-2009. If you were young and just starting to invest, it would be a blow, but you’ve had time to recover. Those near retirement that lost most of their retirement savings didn’t have asset allocations that were conservative enough and it hurt. A lot.
But those that were near retirement and had their allocations set up correctly for that period of their life were okay overall. Yes, they probably lost some money, but not as much as if their investment allocations were taking on too much risk and volatility.
How to decide your allocation
Whether you go all-in on equities, do a 70/30 split of stocks and bonds, opt for 65% equities broken out in specific percentages per sector and then a similar breakdown for bonds and commodities is up to you. There are tons of asset allocation strategies out there.
It all depends on your needs and risk tolerance.
DIY asset allocation
If you like figuring out asset allocation on your own, great! It’s what we do, though we do reference some research in the process.
The DIY approach means you decide on the allocation on your own as well as choosing investments for each. You also need to rebalance your portfolio on your own.
For assistance, you might look at some of the Bogleheads lazy portfolios or the lazy portfolios featured at MarketWatch. There are also great books on investing that talk about asset allocation. Most of these assume you are investing for retirement so they adjust asset allocation by age.
There are ways to make it a bit easier, though.
Automated asset allocation
If you decide you will retire in 2050 (about 30 years from now), you might opt to choose something like a 2050 target date retirement fund which might have 90% of investments in stocks and 10% in bonds.
Target date funds automatically choose the asset allocation based on your stated risk tolerance and retirement date and adjust allocations as time progresses. As the target date nears, the investments become more conservative. A 2020 target date retirement fund might be closer to 53% stocks, 40% bonds, and 7% cash equivalents.
Then there are robo-advisors such as Blooom, or even a real live person you can talk to (a financial planner) that can help assess your risk tolerance and suggest appropriate allocations with periodic adjustments.
Summing it up
Just as you are might choose how to divide up your belongings amongst vehicles with very different drivers, you want to allocate money in your investment portfolio in a way that best suits your needs.
What is right for someone else may not be right for you, and only you can decide the amount of risk you can handle given your timeline.
Asset allocation may be the most influential factor that determines the success of your investment portfolio.