A groundbreaking paper published in 1986 found that asset allocation is not only important but also the primary factor driving a portfolio’s return. Interestingly, the meticulous selection of individual investments within the portfolio and the timing of market entry are found to be comparatively less influential. The magnitude of the disparity discovered in their study is truly staggering: asset allocation alone accounts for an astounding 93.6% of the variation in a portfolio’s quarterly returns. This underscores the significance of carefully considering and optimizing asset allocation strategies when aiming for long-term investment success.
What is Asset Allocation?
Asset allocation is the cornerstone of a well-structured investment portfolio. It refers to the process of strategically dividing your investments across different asset classes, such as stocks, bonds, cash, real estate, and others. The goal is to create a mix that aligns with your specific risk tolerance, financial goals, and investment time horizon.
Think of asset allocation like building a recipe. Just as combining different ingredients creates a balanced meal, carefully allocating your money across various assets aims to achieve a balanced portfolio. A good asset allocation strategy helps you manage risk while seeking potential returns that suit your needs. It’s important to note that asset allocation isn’t the same as trying to pick individual stocks that will outperform the market – it’s about focusing on the overall composition of your portfolio.
Types of Asset Classes
Let’s take a closer look at the main asset classes commonly used in asset allocation:
- Stocks (Equities): Stocks represent ownership shares in companies. They offer potential for high long-term returns but come with greater volatility. Stocks can be categorized by company size (large-cap, small-cap) or investment style (growth, value).
- Bonds (Fixed Income): Bonds are essentially loans you make to corporations or governments. They typically generate regular interest payments and are less volatile than stocks. Bond types include government bonds, corporate bonds, and high-yield bonds.
- Cash and Cash Equivalents: This category includes highly liquid assets like savings accounts, money market funds, and short-term certificates of deposit. They offer a low return but provide stability and easy access to your funds.
- Real Estate: Real estate investments can be made through direct property ownership or real estate investment trusts (REITs). They can provide income, potential appreciation, and diversification benefits.
- Commodities: Commodities include raw materials like gold, oil, and agricultural products. They can offer a hedge against inflation but carry significant price volatility.
- Alternative Assets: This broad category includes investments such as hedge funds, private equity, and venture capital, which often seek higher returns with higher risk.
Factors That Influence Your Asset Allocation
Determining the right asset allocation isn’t a one-size-fits-all solution. Several key factors will shape your ideal portfolio mix:
- Risk Tolerance: This refers to your ability and willingness to handle fluctuations in the value of your investments. A higher risk tolerance may allow for a larger allocation to stocks, while a lower risk tolerance might favor more bonds and cash.
- Time Horizon: Your time horizon is how long you plan to invest before needing to access your funds. Longer time horizons generally allow for more aggressive asset allocations, as there’s more time to ride out market downturns.
- Investment Goals: Are you saving for retirement, a down payment on a house, or your child’s education? Your specific goals will influence the level of risk you’re comfortable taking.
- Financial Situation: Your overall financial picture, including your net worth, income, and debt obligations, should be considered when building your portfolio.
How to Determine Your Ideal Asset Allocation
Here are some ways to figure out the right asset allocation for you:
- Risk Profiling Tools: Many online questionnaires and calculators can help you assess your risk tolerance. These tools provide a starting point, but it’s essential to be honest with yourself about your comfort level with market fluctuations.
- Target-Date Funds: These are mutual funds that automatically adjust their asset allocation over time, shifting towards more conservative investments as you approach your target retirement date.
- Financial Advisor: A financial advisor can provide personalized guidance on asset allocation. They can help you assess your unique circumstances and develop a plan aligned with your goals.
Asset Allocation Strategies
There are several common asset allocation approaches you can choose from:
- Strategic Asset Allocation: This strategy involves setting fixed percentages for each asset class and maintaining those allocations over the long term. Rebalancing is performed periodically to bring your portfolio back in line with your targets.
- Tactical Asset Allocation: This approach allows you to adjust your asset allocation based on current market conditions. For example, you might increase your allocation to stocks during a bull market and shift more towards bonds during a bear market.
- Age-Based Asset Allocation: This time-tested strategy suggests gradually reducing your allocation to stocks and increasing your bond allocation as you approach retirement. One common rule of thumb is subtracting your age from 100 or 110 to determine your stock percentage. There are also various online calculators you can use.
Rebalancing Your Portfolio
Rebalancing is an essential part of maintaining your desired asset allocation. Over time, certain asset classes may outperform others, causing your portfolio to deviate from your original targets. Rebalancing involves selling assets that have become overweighted and buying assets that have become underweighted.
There are two main rebalancing methods:
- Time-Based Rebalancing: Rebalance your portfolio at regular intervals, such as annually or quarterly.
- Threshold-Based Rebalancing: Rebalance when any asset class deviates from your target allocation by a certain percentage, for example, by 5% or 10%.
Asset Allocation Examples
Let’s look at some sample asset allocations based on different risk profiles to provide a clearer picture:
(1926-2020)
Average annual return: 6.1%
Best year (1982): 45.5%
Worst year (1969): -8.1%
Years with a loss: 19 of 95
(1926-2020)
Average annual return: 8.7%
Best year (1982): 33.5%
Worst year (1931): –22.5%
Years with a loss: 20 of 95
(1926-2020)
Average annual return: 10.3%
Best year (1982): 54.2%
Worst year (1931): –43.1%
Years with a loss: 25 of 95
Asset Allocation FAQs
- How often should I review my asset allocation? Review your asset allocation at least annually or whenever you experience a significant life change (marriage, new child, job change).
- Can I change my asset allocation? Yes! Your asset allocation should evolve with your circumstances and goals. Don’t be afraid to adjust as needed.
- What are the risks of improper asset allocation? If your portfolio is too aggressive, you might experience significant losses during market downturns. If it’s too conservative, you might not be able to keep up with inflation and reach your long-term goals.
- Where can I find asset allocation calculators or tools? Many financial websites offer resources to help you calculate your asset allocation. Here is ours: https://einstokwealth.com/risk-score/
Conclusion
Asset allocation is a fundamental principle for any successful investment strategy. By understanding the different asset classes, the factors that influence your choices, and various allocation strategies, you can build a portfolio that balances risk and potential returns in a way that aligns with your goals.
Remember, asset allocation is not a set-and-forget process. Regularly review and rebalance your portfolio to ensure it stays on track. If you’re unsure about the best way to approach asset allocation, consider working with a financial advisor who can help you make the right choices based on your unique circumstances. A personalized approach can work wonders, especially when compared to the DIY process, and so it is a good idea to consider if you should hire and advisor or do it yourself.
Call to Action
Are you ready to take control of your financial future? Schedule your introductory call today to discuss your investment goals and develop a personalized asset allocation strategy.
When determining which index to use and for what period, we selected the index we deemed a fair representation of the characteristics of the referenced market, given the information currently available.
For U.S. stock market returns, we use the Standard & Poor’s 90 Index from 1926 to March 3, 1957, and the Standard & Poor’s 500 Index thereafter.
For U.S. bond market returns, we use the Standard & Poor’s High Grade Corporate Index from 1926 to 1968, the Salomon High Grade Index from 1969 to 1972, and the Barclays U.S. Long Credit Aa Index thereafter.
For U.S. short-term reserves, we use the Ibbotson U.S. 30-Day Treasury Bill Index from 1926 to 1977 and the FTSE 3-Month U.S. Treasury Bill Index thereafter.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.