Finding the Right Asset Allocation

Asset allocation is the allocation of money across different types of investments (stocks, bonds, real estate, etc.). Because different types of investments have different returns and risks, getting asset allocation right is extremely important.

This blog post discusses how to choose an asset allocation.

More Risk, More Expected Return

Everyone has heard the saying, “no risk, no reward.”

In finance, the saying is modified to, “more risk brings more expected return.” The point is that higher expected returns come from taking more of the right type of risk (the right type of risk is discussed more below).

To make the saying more concrete, compare the returns of two diversified portfolios over the past 20 years. One portfolio consists of stocks comprising the S&P 500. The other portfolio is comprised of bonds using the Barclays Global Aggregate Index. Over that period, the stock portfolio’s annual total return beat the bond portfolio 6.2% to 4.1%.

Does that make the stock portfolio better for you? Not necessarily. In that same period of time, stocks lost more than 40% of their value two times.

Asset Allocation to Match Risk Tolerance

Choosing an asset allocation is about making a trade-off between higher expected return and higher risk. People who want the maximum return and don’t mind the value of their portfolio swinging up and down can allocate most of their portfolio to stocks. Over the long run they will see the highest returns.

People who worry about their finances and get nervous when the value of their portfolio falls should invest less in stocks and more in less volatile investments like corporate bonds.

How should you choose? Consider these factors:

How Much You Worry. If you check your portfolio value and get nervous when it falls, take less risk. Although it will lower your expected return, if will allow you to sleep better at night.

Time Horizon. Riskier investments bring higher returns over the long run. If you need to use your money soon then take less risk. For example, if you are in your early 60s and plan to retire soon, investing heavily in stocks may be a bad idea because you could lose a lot of your nest egg right before you need it. On the other hand, if you are in your early 20s and don’t need your money for 40+ years, then you can afford to invest more heavily in stocks.

Need. The more you need to use your money the less risk you should take. If you don’t need to use your money you can take more risk and increase your expected return. On the other hand, if you will rely on your money for retirement or major purchases, then you should reduce the amount of risk you take.

Asset Allocation Benchmarks

There are benchmarks to consider when setting asset allocation. Unfortunately, none of these benchmarks works perfectly.

The 100 Minus Your Age Rule of Thumb

An old rule of thumb is to invest 100% minus your age (in percent) in stocks. So, if you are 40 years old, you would invest 60% of your portfolio stocks. If you are 80 years old, you’d invest 20% of your portfolio in stocks.

This rule of thumb can serve as a starting point, but it is crude and not tailored to anyone’s particular situation.

Target Date Fund Allocations

The major investment companies all have “Target Date” funds that adjust their asset allocation for you as you approach the date when you need the money (presumably when you retire). We can look at how those funds invest.

Interestingly, the different investment companies all allocate differently even for funds with the same target date! And, in the 2008-2009 financial crisis, many 2010 Target Date funds lost up 40% or more of their value – not what you’d hope for a fund whose monies would be needed in 1-2 years.

Other Considerations

As you select your asset allocation, take into account these other considerations:

Cash is an Asset Class. You can essentially eliminate risk by putting money into cash or cash equivalents (like CDs and money market funds). Today you can get close to 2.5% return in a money market fund or CD. This is much better than 0.10% in a savings account.

Not All Risk Increases Your Expected Return. If you don’t diversify your investments you are taking risk that doesn’t increase your expected return. Not diversifying is gambling – it increases your risk but it doesn’t increase your expected return.

Rebalance and Review Asset Allocation Regularly. Once you establish an asset allocation you are comfortable with make sure to review your asset allocation and rebalance regularly. Over time, your asset allocation will deviate from your target as some assets grow more quickly than otherse; rebalancing will bring your portfolio back in line with your preferences and has been proven as a way to increase return over time.

Avoid Leverage. Leverage (borrowing money to invest) is a way to increase your risk and should, theoretically, increase your expected return. Unfortunately, there are costs associated with using leverage (whether through buying on margin or investing in a leveraged fund). Because of these costs, the expected return doesn’t increase enough to justify the use of leverage.

Consider Tax. Once you’ve decided on an asset allocation consider the tax implications of how you will achieve that allocation. It is generally a good idea to put higher-yielding assets in retirement accounts to reduce income tax burdens.

Because of the various complicating factors, you may want to speak with a financial adviser to help figure out your approach.

If you have questions, call Archer Row Advisory today at (818) 539-8808 or click here to leave a message.