One of the key steps to investing is deciding on your asset allocation. What is an asset allocation you ask? It’s the relative amounts of different asset classes in your portfolio which will determine how much risk your portfolio has.
An asset class is a grouping of similar investments whose prices tend to move together – in other words their price movements are at least partially correlated. Asset classes can be defined on a very general level, such as stocks or on a more specific level, such as oil companies. Since most oil companies make money based on similar variables such as the price of oil, it stands to reason that most oil company stock prices will frequently either go up together or go down together.
The concept of asset classes is important because one of the goals when building an investment portfolio is to use asset classes which are not correlated with each other. The idea is that if one of your asset classes performs poorly (such as stocks in 2008), then your other asset classes (such as cash) will help make up for it. This works the other way as well – if stocks do well, then your other asset classes will probably lower the overall return. The reason for doing this is to lower the volatility of your portfolio – if you own all stocks then you could have years where you have -40% returns or +40% returns. If you own a mix of stocks, bonds and cash then your best and worst years will be a lot less dramatic than the all-stock portfolio.
Some general asset classes:
- Stocks – This could be individual company stocks or shares of a stock mutual fund, etf or index fund.
- Fixed Income – Any type of bond, bond mutual fund or certificate of deposit.
- Cash – Usually money in a high interest savings account but could also include money carefully hidden under your mattress.
There are many different definitions for asset classes so it is important to learn the general asset classes (stocks, bonds, cash) and then learn about more specific classes only if they are applicable.
Now that we know about asset classes then let’s get on with some asset allocationing!
Asset allocation refers to how much of the various asset classes you have in your portfolio. An older, more conservative investor might have a retirement asset allocation of mostly fixed income investments whereas a younger, more aggressive investor might have most of their investments in stocks. The basic asset classes of stocks, fixed income and good old hard cash are the building blocks of an investment portfolio.
How to apply asset allocation strategies
Lots of people make the mistake of thinking you need to choose between all risky assets (stocks) or all safe investments (cash) but in actual fact you should pick a happy medium. Riskier assets like stocks have a higher rate of expected return so if your time horizon is long enough, don’t avoid stocks completely just because they are more volatile than fixed income or cash.
Sample portfolio asset allocation
A retirement account with a long investment time horizon might have an 80/20 mix where 80% of the portfolio is invested in stocks and 20% is invested in bonds. If this is too volatile for your stomach and you are having a hard time sleeping at night then instead of switching all the stocks to bonds or cash then just change your asset allocation to a less risky profile such as 60/40 where 60% is stocks and 40% is bonds.
Investment time horizon
The length of time until you need your investment is known as the investment time horizon. Some asset classes such as cash are very safe. If you have $5,000 in a savings account then you can sleep very well knowing that in 6 months you will still have at least $5,000 in that account. If you put your $5,000 into a riskier asset class such as stocks (ie a stock mutual fund) then in 6 months your investment might be worth more than $5,000 or it could be worth less than $5,000 (possibly a lot less).
If you are investing money you don’t need for a long time (ie 20 years) then you might consider investing it in riskier investments such as a stock mutual fund. If you need the money in a shorter time period (ie 6 months) then you should invest it in a very safe asset class such as cash (ie high interest savings account). When evaluating risk its important to note that the idea is to try to maximize the likelyhood that your money will be there when you need it. If you are saving for a house downpayment that you need in 1 year – the return you get in that year is not as important as the need for that downpayment to retain its value.
Another factor to consider is that for someone approaching retirement – they might want to start withdrawals from their investments in a few years but most of the money won’t be needed for many years after they start retirement. Going to a 100% portfolio in that situation is probably too conservative.
Sleep at night factor
It is difficult for the average investor to watch their portfolio value take wild swings every time the markets jump up and down. Lowering the amount of risk in your portfolio by increasing the safer investments (ie more bonds, less stocks) will help you sleep better at night if that is a problem.
An important part of investing is to occasionally rebalance your investment portfolio. Portfolio rebalancing is accomplished by occasionally resetting the proportions of each asset class back to their original percentage.
Let’s look at a rebalancing example
Susan has just won $50,000 in a lottery. After doing some reading she decided that her portfolio asset allocation will be 60% stocks and 40% bonds. One year later, Susan checks out the value of her portfolio and notices that the stocks make up 55% of the portfolio instead of the original 60% she wanted. The bonds are now 45% of the portfolio instead of the original 40%. Susan decides to rebalance her portfolio so the asset allocation is the same as when she started.
To accomplish this she decides to sell some of the bonds and use the money to buy some stocks. Another option for her would be to make any new contributions to the stock portion to try to get it back up to the original allocation.
What is the purpose of rebalancing?
- Potentially increase returns – By selling asset classes that have risen in value and buying other asset classes that have dropped you are selling high and buying low.
- Maintain original asset allocation – Susan had decided that she wanted a 60/40 allocation – if she never rebalanced then it is possible that her allocation (and investment risk) could change from her intended levels.
There you have it – determining the best asset allocation for your portfolio involves a combination of:
- Investment time horizon – when do you need the money?
- Risk profile – can you handle the ups and downs of the stock market?
- Rebalancing – this is something you should do once a year or so.