What is Asset Allocation?
Looking at your investment portfolio, you may notice a breakdown of all the different types of assets you invest in. This is your asset allocation. It’s the practice of dividing investments among different asset classes, such as bonds and stocks, to balance risk and reward according to personal investment needs. It’s important not only to understand your asset allocation, but to manage it.
Strategic asset allocation is the key to setting and maintaining risk tolerance in your portfolio. It’s also the best way to ensure you’re investing in assets that you understand and believe in. For most people, asset allocation is rarely fixed and will change naturally as assets appreciate and depreciate in time. Moreover, a multitude of other factors (such as your age) may dictate how you choose to allocate your assets. To that end, it’s worth understanding the ins and outs of allocation.
Strategic Asset Allocation
The practice of strategic asset allocation involves establishing set targets for wealth distribution across different types of investments. In a typical portfolio, this includes cash, stocks, bonds and commodities. Setting levels for each type of asset allows you to control risk and pursue your investment thesis. Over time, an investor would then buy and sell different assets to restore the original allocation. It’s a practice known as rebalancing.
What is Rebalancing
Over time, the value of different assets will change. They appreciate and lose value at different rates. To stay true to an allocation strategy, investors need to rebalance. This involves selling and buying assets to realign the portfolio.
For example, say that your stock portfolio has an allocation of 50% biotech stocks, 30% telecom companies and 20% financial stocks. After one year, the wealth allocation in your portfolio may be 44% biotech, 28% telecom and 26% financial. To rebalance, you’d sell financial stocks and buy the difference in biotech and telecom companies, to reestablish the allocation.
Rebalancing doesn’t always mean reverting to the original allocation, either. Economic climates change and so do investment goals. Rebalancing is often a healthy way to reassess risk and redistribute wealth in a more advantageous way.
Allocation to Control Risk
Establishing specific allocations for each type of asset in your portfolio is a form of risk management. Each major asset class comes with its own inherent level of risk based on volatility. Equity securities tend to carry more volatility, which is why stocks are riskier investments than bonds—debt equities with low-to-no volatility. Asset allocation with these risk levels in-mind looks very different depending on a person’s tolerance. Take these different allocations, for example:
- Aggressive: 92% stock, 2% bond, 2% commodities, 4% cash
- Moderate: 80% stock, 10% bond, 6% commodities, 4% cash
- Conservative: 65% stock, 22% bond, 3% commodities, 10% cash
Investors seeking to maximize potential gains will take on more risk with a stock-heavy portfolio. Those with a lower risk tolerance may opt for a more conservative allocation.
The most popular form of asset allocation is age-based allocation. It’s a simple rule of thumb that says the older you are and the closer you get to the end of your investment time horizon, the more conservative your allocation should become. This is because less time left to invest means less chance of recovery in the event of negative volatility.
Conversely, younger investors have a much longer time horizon ahead of time. There’s more time for compound interest to accumulate and opportunity to recover in the event of an economic downturn. Younger investors can bear the burden of risk allocation and should do so, adjusting as they age.
There is No “Perfect Allocation”
While many financial advisors will tout an “ideal allocation” or a secret allocation formula, the fact is that there’s no such thing. Optimal asset allocation depends on the person and the many factors present in their life. Age, income, debts, outlook and dozens of other factors dictate a person’s risk tolerance and, inevitably, their asset allocation.
Moreover, asset allocation requires evaluation at least annually. Investment factors change over the course of a year, which means investors need to reevaluate their capacity for risk and their allocation thesis. It’s important not to let emotions factor in here. The concept of asset allocation is to remove emotional decision-making from the investment landscape. Getting too intricate in assessing allocation invites emotions back in, which can cloud an investor’s judgement.
Don’t have the confidence to maintain your own asset allocation? Enter: target-date funds. These are asset-allocation mutual funds that rebalance annually and change their allocation as they approach the target date. For example, if you invested in a 2035 target-date fund in 2015, that fund would gradually rebalance over a 20-year span. Most target-date funds shift from aggressive allocations to conservative ones during their maturation. Many people use these funds as their retirement drivers, since there’s no manual rebalancing required to adjust for risk.
The drawback of target-date funds is that they’re algorithmic and adjust as a reflection of the fund, not the individual investor. You might have a higher (or lower) risk tolerance than the fund balances for at a given time in its maturation cycle. That’s the cost of automation convenience.
Discover Your Ideal Asset Allocation
Every long-term investor would do well to consider strategic asset allocation. Establishing risk and balancing to manage your portfolio is a great way to take a hands-on approach that’s measured and responsible. Scheduled balancing is a good habit to get into, and can help you maintain a strong, diverse portfolio—especially when your appetite for risk changes.
Asset allocation is vital to having a balanced portfolio that can lead you on a path to financial independence. To learn more, sign up for the Liberty Through Wealth e-letter below. You will gain instant access to daily investment tips, analysis and more from some of today’s leading experts on Wall Street!