Investing Terms: Asset Allocation
I argued last week that investing is an important part of reaching your financial goals. There are two reasons for this. You need to overcome the burden of inflation, and you need to allow your money to “work for you” over the long-term.
The natural next question is: How?
This week I’ll take the topic a step further and talk about how ‘asset allocation’ ties into your financial goals. Before I dive in, I have to tell you that investing involves risks. I’m not making any specific recommendations here. Treat any examples as a guide, not an answer to what you should be doing. See my disclosures here.
Defining Asset Allocation
Let’s pretend you have $100 to invest. How would you invest it? You might say, “stocks and bonds.” Great. How much will you put into stocks and how much will you put into bonds? This is the essence of what advisors call, “making the asset allocation decision.” It’s the process of deciding how much money you’ll invest in each asset class.
Whoa, what’s “Asset Class”?
Asset classes are types of investments you can invest your money in. The list of what you can invest in can be very long. But for the vast majority of people, the asset classes you should focus on are:
- Real Estate
But even these asset classes can be broken down into more granular asset classes. Let me give you some examples.
Domestic U.S. Stocks
- Large capitalization stocks (i.e. Apple, Wal-Marts of the world)
- Small capitalization stocks (i.e. smaller companies)
- Value stocks
- Developed international stocks (Europe, Japan, Canada, Australia)
- Emerging market stocks (e.g. China, Brazil)
- U.S. Government Bonds
- Corporate Bonds
- High-yield Bonds (i.e. bonds of riskier companies)
- Municipal Bonds
- International Government Bonds
- Emerging Market Bonds
Other Asset Classes that you can invest in:
- Real estate
- Gold & other commodities
- Jewelry, paintings, wine
I could easily list 1-2 dozen more asset classes. A lot of ‘advisors’ will try to convince you that you need to invest in more complicated stuff to be successful. I disagree. The vast majority of us investing for retirement and college for their kids do very well with a simple mix of Stocks, Bonds, and Cash.
Need to Know: Stocks/Bonds/Cash Risk & Returns
There is a trade-off between the risk you take with an investment and the returns you can make. Very simply, the lower the risk of the investment, the lower the returns. On the flip side, the higher the risk of the investment, the higher the potential returns you can earn.
Check out this historical data from Credit Suisse and the London School of Economics. The red box highlights the historical asset returns for each asset class (nominal = before inflation). The green box highlights the best and worst years for each asset class.
Let’s look at Bills first, which is another way of saying “cash.” Investing your money in cash is low-risk. If you put $100 in the bank, you’re assured that you’ll never have less than $100. The trade-off? You earn low returns. In fact, interest rates are near historical lows today and it’s hard to earn more than 2% in a savings account.
Bonds offer somewhat better returns but also involve more risks. Bond prices can go up and down. Meaning, if you put $100 into a bond, it may be worth more (or less) than $100 at the time you’re ready to sell it. The trade-off? You’ll likely earn returns that are better than a savings account. Again, interest rates are low today. So a typical diversified bond fund today yields anywhere from 3-4%.
Stocks (equities) are riskier than both bonds and cash. But they offer better investment return potential. Looking at the table from Credit Suisse again, you can see that average stock returns since the Year 1900 are around 9.5% per year. Sounds great, right? But look at the “worst year” column. Stocks can be extremely volatile and go down a lot in any given year. Heck, as recently as 2008, the S&P 500 stock index was -38%. In one year! How would you feel if you had $100,000 in your retirement account on January 1, 2008, and ended 2008 with $62,000? Not good!
The takeaway: Over LONG periods of time, stocks do better than bonds which do better than cash. But stocks are riskier and volatile.
How to Determine Your Asset Allocation
When you’re making an asset allocation decision, the two primary questions you need to ask are:
- What is my goal, and how far into the future will I need this money (time horizon)?
- What is my risk tolerance? A lot of people struggle with volatility in the stock market.
Time horizon is a huge factor in deciding your asset allocation. The shorter the time horizon for your goal, the less risk you’d want to take. The longer your time horizon, the more risk you can take.
If you’re saving for a downpayment on a house, it wouldn’t be wise to invest that money in the stock market. The last thing you want to do is lose 20% of your down payment in the stock market just as you’re getting ready to buy the house. But it’s easier to ‘weather the storm’ in stocks when you have a long-term goal like retirement. Particularly if you’re not going to retire for 10, 20, or 30+ years.
The other question you need to ask yourself when deciding your asset allocation is, “What’s my tolerance for risk?” There are online risk tolerance questionnaires such as this one from Vanguard that can help you assess your risk tolerance. But my experience is that you don’t truly know your risk tolerance until you’re in the middle of a declining stock market.
Investing money can be an emotional rollercoaster if you’re not prepared. That’s why I strongly advocate working with someone experienced in managing the ups-and-downs of the market. A good financial advisor is as much a coach as they are a number cruncher. Anyone can do the math and tell you what asset allocation you should have. But if they’re not able to coach you to hang tight during a stock market decline, then their asset allocation advice will prove worthless.
Investing Is Not Set-it-and-forget-it
It might be tempting to think that you can figure out your asset allocation, make the required adjustments to your investments, and then get on with life. You shouldn’t. You need to go back each year and perform what’s called a ‘rebalance.’
Example. You have $10,000 to invest for retirement, which is 30 years away (long-term goal). You also took a risk tolerance questionnaire which said you should invest 80% of your money in stocks and 20% in bonds & cash. So $8,000 in stocks, and $2,000 in bonds & cash.
Now let’s assume the stock market has a great year and goes up 20% while bonds decline 3%. At the end of the year, you will have $11,540 ($8,000 of stocks that went up 20%; $2,000 of bonds that declined 3%). Look at your year-end asset allocation: you now have 83.2% of your account in stocks and just 16.8% in bonds & cash.
Rebalancing is important to keep your investments in line with your time horizon and risk tolerance. If the stock market has a couple of good years in a row, as it did recently, it’s very easy to find yourself with too much exposure to stocks. Too much exposure to stocks = too much risk.
By rebalancing, you are essentially selling investments that go up while buying investments that went down. In the investment world, we call this “Buying low and selling high.” It’s the key to successful investing.
Asset allocation is all about how you invest your money between stocks, bonds, and cash. You do that by looking at the time horizon of your goals (short, medium, long-term). The shorter the goal, the more conservative you want your asset allocation to be (more cash/bonds, fewer stocks). The longer the goal, the more aggressive you can afford to invest (i.e. more stocks, less cash/bonds).
You also need to assess your tolerance for risk. It’s harder to measure this. But it’s important for you to realize that investing can elicit emotions (fear, greed) in ways you can’t imagine until you’re going through them.
An ideal asset allocation balances the time horizon of your goals with your investment risk tolerance. Once you identify your ideal asset allocation, you want to make sure that you are “rebalancing” each year to make sure your investments stick close to that allocation.
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