What is Asset Allocation?
Asset Allocation is one of the most important factors in investment returns; at least as, if not more, important than market timing and security selection (collectively called active management).
When you hire an investment manager to manage your investment accounts, you're paying for (active) management of your portfolio AND asset allocation. BUT when you hire two investment managers (read: multiple accounts with multiple financial advisors) who aren't responsible for what the other is doing, that means YOU (knowingly or not) are responsible for coordinating the asset allocation. The same can be said if you're managing you own money, like a 401(k).
Many investors who either have multiple accounts with multiple advisors or are managing their own funds rarely have the tools or resources to monitor the overall asset allocation of their portfolio. This is a BIG responsibility, one that could have a large impact on investment results.
So what is Asset Allocation and how can you implement it?
Asset Allocation is a strategy that investors use in the investment selection process in order to balance the RISK of investing with the REWARD of investing. It's closely tied with diversification, or the "don't put all your eggs in one basket" approach (which we'll discuss in a bit).
Let's Get Started: Considerations
There are 3 main considerations in selecting the appropriate asset allocation strategy that are entirely individualistic:
Risk Tolerance is your ability to handle fluctuations in the value of your portfolio, i.e. market volatility, and typically ranges from Conservative to Moderate to Aggressive (to Speculative, in certain cases).
Time Horizon is the time period over which you will be investing and is usually tied to a specific Financial Goal. For instance, if you are a 40 year-old saving for Retirement (the Goal), you might have a 30-40+ year time horizon. If instead you were saving to buy a house or pay for kids' college, the time horizon might be much shorter (maybe 5-10 years). Different time horizons and goals can dictate how conservative or aggressive your portfolio can be.
As the saying goes, different strokes for different folks. The important thing to note is that any appropriate asset allocation strategy will have a foundation built on these factors.
Picking Asset Classes: The First Step in Portfolio Construction
Now that we have considered what we are investing FOR, it is time to decide what we are investing IN. To simplify, let's look at 3 typical Asset Classes:
Cash & Equivalents
Fixed Income / Bonds
Equities / Stocks
Cash and cash equivalents (like money market or CD's) are typically a very liquid and very conservative asset class. The primary risk(s) associated with cash is that it often pays very little interest, possibly not enough to keep up with inflation (the gradual increase in prices of things you buy year over year).
Fixed Income investments (or bonds) are often loans to corporations/financial institutions/governments that pay interest back to you throughout the life of the loan, with the expectation of getting your principal back at the end of the term. Without going into too much detail regarding all the risks of fixed income assets, for now we can say that bonds are sensitive to changes in interest rates and the credit quality of the corporation/institution/government borrowing the money. The reward of bonds is typically an income stream that pays more than cash over the long run.
Equities (or stocks) are shares of ownership in a company. Sometimes (at the board's discretion) as an owner you are entitled to a share of the company's earnings each year (called a dividend), but it is not guaranteed and often not granted by most stocks. Again, without going into too much details regarding the risks of equity investments, stock valuations are sensitive to perceived future earning potential. Perceived changes (big or small) in the economic picture tend to make the most waves, with big moves coming around surprises in expectations.
Most portfolios will contain a mix of these asset classes. Each mix will have a different risk/reward profile (based on historical return numbers), and selecting an appropriate mix is the first step to portfolio construction.
The Efficient Frontier
Past performance is no guarantee of future results. Risk and return are measured by standard deviation and arithmetic mean, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © Morningstar. All Rights Reserved.
The Efficient Frontier (above) is a nice illustration of how different allocations of two asset classes (Stocks & Bonds) can change the risk/reward profile of a given portfolio. Historically, the efficient frontier has drifted left, right, up, and down, but the overall shape has relatively stayed the same over a long-term investing time horizon. Year-to-year changes can vary drastically, sometimes looking upside down when equities perform terribly. But for the most part, this "normal" efficient frontier looks how you'd expect over time.
The Second Step: Security Selection
Once you've determined the appropriate asset class mix (and thereby, where you fall on the risk/return spectrum), selecting the individual securities that make up each class is where the easy work ends (and typically the professional investment advisor's job begins). Not because it is difficult to figure out, but because there are endless securities to choose from!
For our purposes here, I'll merely mention a few different factors for securities that you can include in your portfolio:
And here are some non-specific examples of what those securities might look like by combining the factors mentioned above:
- 3 month US Treasury Bill
- "Your Bank of Choice" 6 month CD
- "So and So's" High Yielding Money Market fund
Fixed Income Examples:
- US Inflation Protected Bond mutual fund
- Global (Currency-hedged) Intermediate Bond ETF
- "ABC Company" Senior-secured Floating Rate Note
- CA Muni Bond
- US Large Cap Growth Fund
- Technology Sector ETF
- "DEF Company" Stock
Putting it All Together
Now that you've got your desired asset class mix and picked the individual securities to make up those asset classes, putting it all together, you have your diversified portfolio!
The process is the same for all your accounts. Each account can have it's own asset allocation tied to a unique financial goal/risk tolerance/time horizon.
So now what?
Just set it and forget it? Maybe not...
Regarding Correlation: We mentioned before that Asset Allocation is a strategy tied closely with diversification. The reason for diversifying into different asset classes is simple: (over time) each asset class behaves differently from the others for different reasons (i.e. not perfectly correlated), and not having all your eggs in one basket can be a prudent investment decision.
Diversification doesn't guarantee against loss, BUT it can help balance out the risks uniquely associated with each asset class. Speaking generally, for instance, adding a small percentage of stocks to an all-cash allocation can help offset the risk of inflation. Or adding a percentage of bonds to an all-stock portfolio can balance out the shocks and big market swings.
But what if stocks and bonds move closer to being perfectly correlated? (which has happened before) Then diversification doesn't work the way it was quite intended, and an asset allocation review can be warranted.
Regarding Life Changes: There are also times when financial goals or time horizons change. This impacts the foundation of your asset allocation decisions and should be cause for another look at your current allocation to make sure it is still working for our new situation.
Regarding Market Changes: The most common reason to periodically review your asset allocation is because markets move. Stocks grow (on average) faster than bonds, and bonds pay interest that collects in cash. Given a short time, your asset allocation percentages will drift away from your target, and you will need to perform a REBALANCE (selling the appreciated class and buying the depreciated class).
Paying Attention: How we help
We believe that paying attention to your asset allocation is important. It can help you can stay on track to meet your goals and add value to your portfolio over time. This is the proposition we present to our clients, and it can apply to you as well.
Whether you manage your own money or have multiple accounts in different places, if you need help identifying the asset allocation of your portfolio we'd love to help you do that. You can call and talk to one of our investment managers (805) 963-6181, or email firstname.lastname@example.org with any questions you might have.