Asset allocation is an important part of investing and one of the few things within your control when it comes to investing.
Not only is it an effective way to manage investment risk, asset allocation also plays a big part in the type of returns you can expect.
In this post, you’ll learn what asset allocation is, how it works, why it is important, how and when to rebalance and so on.
What Is Asset Allocation?
Asset allocation refers to the exercise of dividing an investment portfolio among different asset classes. It is an investment strategy that allows investors to potentially minimize risks and maximize investment returns by choosing the type of investments that align with their personal situations.
When you want to start investing, thinking of which stocks or bonds to buy is the wrong approach. That should come last.
An effective investment strategy should begin with understanding and determining how the different asset classes will help you achieve your financial goals. And that is where asset allocation comes in.
What Are Asset Classes?
An Asset class is a group of securities or investments that have similar characteristics such as the risk, returns, how they are traded or even regulated by the government.
The main asset classes in asset allocation include:
- Equities (stocks or shares, stock ETFs)
- Fixed income (Bonds or bond funds)
- Cash or cash equivalents
Other asset classes include commodities, real estate or property, currencies, futures and other derivative instruments.
Understanding asset classes, and their characteristics, is important because they are the foundation of an asset allocation strategy.
Why Is Asset Allocation Important?
According to this research from Vanguard, asset allocation, and not the ability to select stocks or time the market, is responsible for the bulk of the returns and volatility in a diversified fund.
In fact, 91.1% of the return variation of an investor in US funds and 86% in Canada funds, can be attributed to the choice of asset allocation.
More importantly, asset allocation can help investors balance the risk in the portfolio against the returns. This is because asset classes have exhibited varying risk and returns historically.
For example, when there is a recession, equities start dropping and investors seek the safety of government bonds. A portfolio’s allocation to equities will drop, but the fixed income portion will rise due to flight to safety – although not necessarily in the same magnitude.
This way, the portfolio will experience a smoother, but not necessarily better, returns compared to another portfolio with 100 percent allocation to equities.
How does Asset Allocation Work?
The starting point is an assessment of an investor’s specific situation to determine the level of risk that can be taken.
An investor questionnaire, like the one here, will come handy. It provides a suggested asset allocation based on a series of questions aimed at determining your investment objectives, time horizon and risk appetite.
Once you have the suggested asset allocation, you can go ahead to buy securities within each asset class. But also remember to diversify.
What should my Asset Allocation be?
Is there a good or best asset allocation? The answer is NO.
There is no ideal asset allocation. The right one depends on each investor’s unique personal circumstances including the investment goals, investment time horizon and risk tolerance.
The 3 factors are explained below:
Your investment goals play a big part in choosing an ideal asset allocation.
All other things being equal, two investors saving for retirement and a house down payment should have different exposures to equities for example.
The investor saving for retirement may be willing to allocate a larger portion of their portfolio to equities, knowing that there’s still time to recover from any short-term drop.
On the other hand, the second investor would want to prioritize the safety of the down payment.
Investment goals are closely related to time horizon.
Time horizon refers to when the investment will be needed. It plays a larger role in picking an ideal asset allocation than just investment goals.
Consider 2 individuals investing for retirement. They both want to retire at 65. One is 30 years old and have 35 years to retirement, while the other one is 60 years old.
Though they have the same investment goal, their time horizons are quite different. The younger investor can weather any market turbulence and be comfortable with a more aggressive or risky portfolio. That is, a higher allocation to equities.
The older investor has a shorter time to when he’ll start withdrawing from the portfolio. A more conservative asset allocation may be more appropriate.
An aggressive portfolio may be ill-advised given that he’s just years away from retirement.
Finally, risk tolerance plays a big role in the choice of the right asset allocation for an investor.
Risk tolerance refers to the degree of variability in returns that an investor can take. In other words, how much money are you willing to lose in exchange for your desired investment return.
No matter how far away an investment goal is, how you will react to a market drop should not be ignored.
Will you panic and sell off the investments even though you’re still 10 years away from needing the money? If yes, you may have a low risk tolerance and should choose a conservative asset mix.
Can you live with short-term volatility and even see a drop as a buying opportunity? You probably have a higher risk tolerance.
Either way, your risk tolerance is only a piece of the puzzle. You should not be too aggressive when your investment goal is just a few months or years away.
So the investment goals, time horizon and risk tolerance should all be considered when thinking of the best asset allocation for you.
Age-based Asset Allocation – Rule of Thumb
Age-based asset allocation is an asset allocation strategy that provides a quick way for calculating how much risk an investor should be exposed to.
Also known as The 100 Rule, it is a rule of thumb that is based on the investor’s age.
Here is how it works:
To know how much your allocation to riskier assets like equities should be, simply deduct your age from 100.
For example, a 60-year-old investor will allocate 40% to equities using this rule.
But remember this is just a rule of thumb and may not be relevant for your personal circumstances.
When Should You Change Your Asset Allocation?
As your investment goals change or you get closer to when you’ll need the money, it may be prudent to make some changes to your portfolio holdings.
For example, having 80% allocation to equities may work great when you start saving for your kid’s college. But the closer you get to when the funds will be needed, the greater the case for a more conservative asset allocation.
However, changing your allocation to different asset classes based on their recent performance is often a bad idea.
As long as the original asset allocation reflects your actual financial situation, you should avoid constant tweaking of your portfolio make-up until it’s time to rebalance.
Asset Allocation and Rebalancing
Rebalancing goes hand in hand with asset allocation. It is the practice of bringing a portfolio back to its original or intended asset allocation.
Why is Rebalancing important?
The different asset classes in an investment portfolio will perform differently, with varying returns over time. Such that a portfolio that started with an allocation to equities of 60% and 40% in bonds, may end up having 80% in equities after a period.
To rebalance the portfolio, the investor has the following options:
- Sell the asset classes that are overweight and buy the underweight assets.
- Allocate new money to the underweight asset classes
- Continue to allocate new contributions to all asset classes but with a higher weighting to the underweight ones.
Any of the strategies above can help to rebalance a portfolio. The first one, selling one asset to buy another, will be faster though it could potentially be more expensive if there are transaction fees for both sides of the trades.
The last 2 should be cheaper but may take longer depending on the size of the portfolio and how much the new contributions are.
Check this Rebalancing Guide for everything you need to know about it.
Diversification Vs Asset Allocation
Diversification refers to the investment risk management strategy of holding different investments or securities in a portfolio. With a diversified portfolio, an investor minimizes the risk that one bad investment will have a material impact on the overall performance of the portfolio.
Diversification may sound like asset allocation, but they are different.
To diversify a portfolio, you need to look at the portfolio on two levels: at the asset class level and then within each class.
Having an asset allocation of 20% each to equities, fixed income, real estate, commodities, and cash equivalent may be diversified at the asset class level. But overall, the portfolio will not be diversified if each asset class is made up of just one or just a few securities.
In other words, allocating your money to different asset classes is commendable. But don’t stop there – also diversify within each asset category.
Doing Asset Allocation The Smart Way
Asset allocation and diversification sounds great, but they can be quite difficult to implement and maintain.
Luckily, there are some easy and effortless ways to get started with a well diversified portfolio without the headache and cost of buying several securities and rebalancing the portfolio periodically.
Here some 3 smart ways to build a diversified portfolio in line with your target asset allocation:
- Robo-advisors: Once you select an ideal asset allocation for your investment objectives, the initial portfolio and all the on-going maintenance will be done by the robo-advisor. All you need to do is to regularly contribute to the account. The catch? You’ll need to pay some management fees for the convenience.
- Target date funds: they invest in riskier assets in the early years, but dynamically move towards a more conservative asset allocation mix as the target date (when the funds will be needed) gets closer.
- Asset Allocation ETFs: Usually made up of a number of ETFs, each covering one of the asset classes, at the investors desired allocation. In general, they’ll be the cheapest of the 3 options. And you may even be able to buy them commission-free with some brokers, for example Questrade in Canada. To learn more about asset allocation ETFs, how to get started, the various options available for U.S. and Canada securities, check out this detailed guide.
Related Post: Asset Allocation ETFs: How Do They Work?
Knowing and choosing the right asset allocation for your investment goals is one of the important investing decisions that all investors should make.
If you like this post, check the other resources below to learn about other investment strategies.