There are three fundamental principles to successful investing: asset allocation, market timing, and time in the market. To achieve optimal financial returns, while balancing an appropriate level of risk, we look at asset allocation.
What is Asset Allocation?
Asset Allocation is an investment strategy that involves investing part of your portfolio in different investment classes; stocks, fixed income, and cash. These assets, or investments, make up a portion of each balanced portfolio. The amount of risk associated with the portfolio is determined by how much of each asset class is held. For example, a 100% stock portfolio is much more risky than a 50% stock, 50% fixed income portfolio.
Okay, so Asset Allocation simply refers to how much of my investment portfolio is made up of stocks, bonds (fixed income), and cash. I’m with you so far, but why are you telling me this?
Why is Asset Allocation important?
As one of the three levers that controls investing, Asset Allocation is the most easily adjusted. While we cannot invest earlier, and correctly timing the market is a statistical impossibility, asset allocation is our best bet to invest effectively.
Asset allocation is widely considered the most important investment decision, with far greater impact than the specific stocks in your portfolio. The asset mix, between stocks, bonds, and cash determines the risk / return rating of each portfolio.
In general, stocks are the riskiest, yet offer the highest returns. Fixed income is safer, but the returns are lower than stocks. And cash, or Certificate of Deposits (CDs), are the safest of all investments, yet yield the lowest returns. Asset allocation is important to understand, as it governs risk and expected returns.
Alright, Asset allocation is important. How do we use it best?
How to use Asset Allocation?
Financial advisers will often recommend asset allocation based on your age, as a general approach to determine how much risk you are open to. The traditional formula is 100 minus Age = asset allocation weighting. For example, let’s say you are 30 years old. 100 - 30 = 70. This means that 70% of your portfolio should be invested in stocks, while fixed income (bonds) and cash make up the remaining 30%.
The traditional formula doesn’t take into consideration the increasing life expectancy, and I would advocate that for our younger readers, the asset allocation benchmark formula should be 115. For our 30 year old reader, that would look like 115 - 30 = 85. Therefore, 85% of a 30-year old's investment portfolio should be in stocks, with the remaining 15% invested in fixed income and cash.
This benchmark system makes a very important assumption, that the investments are made with a long-term focus. This long-term focus looks towards retirement, not shorter term financial goals like home-buying or weddings. If the monies will be needed within the next 5 years, a far more conservative asset allocation is recommended.
Key Learning Notes:
Asset allocation is the single most important lever to control your financial investments. The term refers to how much you invest in a single area, between stocks, fixed income (bonds), and cash. The more heavily weighted in stocks, the riskier the portfolio, and the higher expected returns. As a general rule, a good benchmark for asset allocation can be established by using 115 (or 100) minus Age = allocation for stocks. This benchmark is effective if using a long term focus, for example saving for retirement.
Perform the asset allocation benchmark calculation for your long term investment accounts. What is your benchmark score?
Now look at your investments. How much, as a percentage, do you have invested in stocks? Fixed income? Cash?
Is there any re-balancing required? Ideally, this exercise is conducted once or twice a year.