web analytics

April 10, 2014



Investing 101: Asset Allocation

(Once again, when it’s Tuesday, that means it is Investing 101 day!  We’re running out of individual investment vehicles to cover, so we’re going to start covering some broader investment concepts.  Today, that means asset allocation, a concept that comes up repeatedly in discussions of investing and personal finance.)

Q: What is Asset Allocation?

A: In general, asset allocation refers to how you have your money distributed among different investments.  The point of asset allocation is to view your portfolio holistically, ensuring that you aren’t taking more risk than you want, or less risk than you need, with the money and resources you have available.

Q: What’s the perfect asset allocation, then?

A: There’s no way I can answer that; no one single perfect asset allocation exists.  It’s a bit like individual investment choices; some people prefer investing in stocks, others in real estate, still others in mutual funds.  Each option could be equally effective at building wealth, it’s simply a matter of personal preference and individual needs with the investment that will dictate the best one for each person.  Similarly, the best asset allocation for you will depend on a number of personal factors.

Q: Alright, how do I determine the best asset allocation for me?

A: There are a few important factors to consider to determine how to build your asset allocation.  The first step is to consider what goal(s) you’re investing to meet.  The big one for most people is retirement, of course; besides being one of the most expensive events in your life, it’s also one of the few you can’t take out a loan to finance.  You might also find yourself investing for college (for yourself or your children) or investing in order to buy a house.  For the purpose of keeping track of your progress, it might be best to think of each of these goals as a separate portfolio, even if in practice they are co-mingled.

Second, know how long you have until you need the money.  The less time you have available to make up any shortfalls, the more conservative you’ll have to be with your investments.  In general, the advice is that any money you’ll need within five to ten years (depending on the source of the advice) should not be invested in the stock market or similar risky ventures.  (As an aside: for goals where you’ll need the money all at once, this means you should be completely invested in bonds, bond funds or cash equivalents five to ten years before the event.  For goals that occur over the space of years or decades, like retirement, you can (and should) remain invested in stocks or other growth investments at the start of your retirement, to maximize the growth of your money and help make sure it lasts through your whole retirement.)

The third consideration is how much growth you need.  If you can save enough money to meet the goal through your own efforts, you can focus on keeping that money safe rather than growing it, by putting it aside in a savings account or other secure cash equivalent.  You won’t see much return, but the money you save will be safe and secure for when you need it.  If you need a great deal of growth (for a huge event such as retirement), you’ll have to put your money into riskier but higher average growth investments like stocks.  (Of course, you still need to balance your need for growth of your money with your time frame; if you try to make up for a short time frame by investing in highly risky ventures, you put yourself at risk of losing even more money and falling even further behind in meeting your goal.  If you have limited time, you should try to boost your savings to make up the difference, not upping your investment risk.)

A fourth consideration is your own tolerance for risk.  Depending on how well you can stomach the ups and downs of the market, you can tweak your portfolio to be slightly less risky or slightly more risky (with a higher average return).  Note that I say tweak; you shouldn’t take a huge amount of risk if you only have a few years left to make up your losses, regardless of how ‘risk-tolerant’ you are, nor should you hide from any risk if you have a long investment horizon and a large amount of money that you need to gain through investing.  While much is made about risk tolerance, ultimately it has to take a back seat to more practical concerns of time and needed growth.  At most, you could shift ten to twenty percent of your portfolio to a more or less risky investment according to your tolerance; that should moderate your returns while still allowing a reasonable level of growth.

Q: Whoa, that’s a lot to think about; care to run through an example asset allocation?

A: Sure, here’s an example of an investment portfolio for retirement, showing how to start, how to shift the investment over time, and where to end up:

  1. Start with stock mutual funds, approximately one-third in a total foreign fund and the rest in a total US stock fund.  (Consider adding more funds to cover other investment classes, like REITs or commodities, but don’t worry about getting too complex.)  Rebalance whenever the ratio gets too far from your desired allocation.  (A five percent threshold before selling off part of the portfolio will keep you from constantly buying and selling within your portfolio.)
  2. About twenty-five years before your intended retirement, switch ten percent of your portfolio over to a bond mutual fund, either a total bond market or total short term bond fund.  Keep the same proportion of US and foreign funds in your stock allocation.  (Ideally, make the switch within a retirement account to avoid paying any capital gains taxes on the growth of your stock funds.)  Rebalance between the three funds as needed, ideally by directing new investment money towards the laggards in your portfolio.
  3. Every five years, continue to build up the bond portion of your portfolio, ten percent each time.  In this way, you’ll slowly scale back on the risk that a bad stock market will deplete your retirement reserves.  Continue to rebalance if your actual allocation gets too far out of proportion.
  4. At ten years to go, start putting the new bond money into a TIPS fund, to provide you with an inflation hedge.  With ten years until retirement, you should have 40% in US stocks, 20% in foreign stocks, 30% in bonds and 10% in TIPS.  Have I mentioned that you should rebalance your portfolio if it gets too far from this allocation?
  5. With five years to go before retirement, ensure that your cash reserves equal three to four years worth of expenses, to give you a buffer if your investments decrease in value.  Add more TIPS to your portfolio, giving you a final portfolio allocation of 33% US stocks, 17% foreign stocks, 30% bonds, and 20% TIPS.  Rebalance when needed.
  6. At retirement, start to live off your cash reserves (as well as any pensions, Social Security payments, or annuities you happen to have).  Put the dividends from your investments into your cash accounts, and when selling your investments (if the dividend income is not enough to meet your needs), try to maintain the same asset allocation you had before you retired (in that way, you’ll automatically be rebalancing your portfolio as you progress).  With a large enough investment portfolio, this method should enable you to live quite well in retirement.

Q: Wow, that’s kind of complicated.  Is this the only asset allocation I should use?

A: Far from it.  This is just a simple, off the cuff allocation progression.  With some effort and a little research, you can probably come up with an even better investment plan of your own, or at least tweak this one enough to meet your personal needs.  It does illustrate some key points about your own asset allocation plan, though.  First, when you have plenty of time to invest, you should invest agressively, using a lot of stocks and other growth investments.  Second, when you are approaching your goal, you should scale down your risk, starting to focus more on preserving what you’ve gained rather than gaining still more.  Lastly, there should be a ‘flight path’, a slow, gradual progression from agressive to safe investments, which you follow over the course of your investment career.

There you have it, some basics on creating an asset allocation and altering it over the course of a lifetime.  Hopefully, these tips will help you as you begin your own investing career.  Good luck, and happy investing!

Comments

  1. I like to recommend people head over to ifa.com and take their risk profile quiz to help determine the asset allocation that works for you.

    I have seen many different numbers, but it is clear from the research that asset allocation is the most important part of a portfolio. Ken Fischer is often quoted as saying that asset allocation determines 70% of your portfolio returns.

    • IFA is a pretty good resource; I’ve been getting their ‘Index Fund Investing Quote of the Week’ for several months now, and the suggestions they make are reasonable. The illustrations are also impressive, but that’s neither here nor there.

      As for asset allocation, I’ve heard a variety of figures, myself. Ric Edelman, whose book ‘The Lies About Money’ I reviewed this past Saturday, quotes a study that attributes 93% of your performance to asset allocation. So, yeah, asset allocation trumps most other considerations when it comes to your investment returns.

Speak Your Mind

*

CommentLuv badge