What is asset allocation? Remember the pie chart you receive in the statements of your retirement account showing you how much of your money is invested in stocks and bonds versus cash? That is an example of asset allocation. It deals with how you split your money in different classes of financial assets.
Asset allocation might be the most important investment decision you need to make. It helps you reach the optimal risk and return balance that fits your own investment needs and personal traits.
A risk management tool. You may ask: Why can’t I just focus on stocks? What benefit can investing in bonds or money market funds bring? Especially considering bonds offer lower returns than stocks.
That’s the right question to ask because stocks offer higher returns on average. But it’s on average. There’s no guarantee that stock index funds will outperform bonds year in and year out. Take 2000-2010 for example, the Standard & Poor’s 500 index actually underperformed Treasury bonds.
[See: 9 Ways to Buy Stocks That Everyone Needs.]
Individual stocks are very risky, with an average volatility about 40 to 60 percent, but if you hold a market index fund, volatility comes down to around 15 to 20 percent, due to diversification. For some investors, even the risk of 15 percent could be too much to handle, not to mention that the drop could be much more than 15 percent in a period of financial crisis.
These investors need to move beyond stocks and invest more into safer asset classes, primarily bonds. Bonds’ average volatility is a lot lower than stocks, unless you choose the more risky high-yield corporate bonds.
Let’s say you choose a bond fund with a volatility of 8 percent. Now between the 15 percent stock fund and an 8 percent bond fund, you can go for 100 percent in stock, or 100 percent in bond, or anywhere in between, say 80/20 mix or 40/60 mix. The result will be a customized portfolio with your desirable risk level.
Of course, when you move into safer assets, you will sacrifice some upside potential.
Who would value safety more than upside returns? It could be investors with low risk tolerance — seeing their investment undergo ups and downs creates anxiety and hurts their quality of life.
Alternatively, it could be investors who can’t afford to lose. These investors typically have timing concerns — they need the money at a very specific time. It could be someone close to retirement age; it could be a couple with kids going to college in two years, or some 36-year-old who dreams of buying a vacation home at the age of 40. For these investors, the utmost priority is to have the money ready at a specific time, because they can’t wait for the market to bounce back.
[See: 10 Ways for Investors to Buy the Market.]
There is no one-size-fits-all solution to asset allocation. How do you decide on your pie chart? For retirement accounts, there is the layman rule of investing in 100 minus your age percentage in stock. No empirical evidence suggests this is the best formula, but the idea captures an important determinant of asset allocation — investment horizon. As you get closer to the retirement age, you value safety more than growing the money, hence less in stock and more in bonds and cash.
You may have heard of a target-retirement fund, also known as a life-cycle fund. These are retirement funds that decide the mix for you. Personally I am not a big fan of these funds because of the cookie-cutter approach they follow. They offer the same asset allocation for all the people aiming to retire in a given year and gradually drop the portion in stocks as time goes by.
Though the target retirement year captures investment horizon, it ignores other factors that are equally important for asset allocation, such as individual risk tolerance level or other financial parameters. To assume people with 20 years to retirement have the same risk tolerance level is an oversimplification. It would be naïve to expect a person who has no kids versus four kids, married or divorced, with rich dad or not, has other savings or not, would all like the same risk and return trade-off.
The power of asset allocation is to find the right mix that fits your individual needs. When you are lumped together with others, you lose that freedom and may end up with a suboptimal investment portfolio.
If you are interested in learning the DIY approach, try an internet asset allocation calculator, such as one provided by Iowa public employees’ retirement system. This calculator captures not only age, but also risk tolerance, current assets, savings and marginal tax rate.
[See: The Top 10 Investment Portfolio for Millennials.]
Remember, risk tolerance changes over time and you need to make adjustments to the mix as time goes by and as personal financial needs change.
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Asset Allocation Is a Permanent Balancing Act originally appeared on usnews.com
