It doesn't matter if you own a billion-dollar hedge fund or got a bond for graduation. It doesn't matter if you day trade with reflexes that would shame a South Korean Overwatch team or if it's been so long that you've forgotten your ETrade password.
If you have money invested in any market, you need to understand asset allocation.
So let's get to it.
What Is Asset Allocation?
Asset allocation largely overlaps with diversification. It's the practice of spreading your portfolio over a range of different investments in order to ensure that they reach their goals.
The short version is that this is investment-speak for "don't put all your eggs in one basket." The longer version comes from the Securities and Exchange Commission's outstanding primer on the subject:
[H]ave you ever noticed that street vendors often sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.
A well allocated portfolio has investments in several different products and markets. It's about understanding the market well enough to spread your investments, and understanding your goals well enough to balance your goals against diversification.
Why Practice Asset Allocation?
At its core, asset allocation is about balancing portfolio growth against risk management.
Allocation for Risk Management
If you were a savant or a psychic the best thing to do with your money would unquestionably be to put every cent into your highest performing asset. You could concentrate an entire portfolio for the maximum possible gains without any wasted capital on underperforming assets.
But you're not a savant or a psychic. Even the most brilliant minds on Wall Street spread their money over a basket of risks, and as for Miss Cleo… Let's just say that tycoons operate few late-night call centers.
So you allocate your assets over a range of investments to protect against shock and failure. In a well balanced portfolio single investments, or even entire categories of investments, can tank without wiping you out completely. By spreading out your money, even if you are an investor seeking higher returns, you manage your risk.
Allocation for Portfolio Growth
Take your money out of every bank, every institution, every investment fund and portfolio you own. Then put it into a series of FDIC insured savings accounts across multiple banks in increments of no more than $250,000.
Congratulations! Your money is about as safe as cash can be. Too bad it's not going anywhere.
This is the other side of asset allocation: achieving your target growth.
You can keep your money in low-yield bonds and Treasury products with a great deal of confidence but the odds are you'll never meet your financial goals. Cautious investing is only useful up to a limit, after which you need to accept a degree of risk in order to capture a meaningful return. Asset allocation is about chasing that return while keeping risk to a manageable level.
Who Should Practice It?
How To Allocate Assets
There's no universal formula for asset allocation. How you should spread your money, and where, depends entirely on your own needs. The major factors you should consider include:
As an investor you should first articulate specific financial goals. Common investment goals include paying for college, buying a house and retirement.
Your investment goals will inform almost every other aspect of your asset allocation strategy such as time horizon and risk tolerance. Most specifically, goals inform your requirements for portfolio growth. Once you've identified your financial goals you can determine how much money you'll need, and on what schedule.
Financial goals should be your foremost concern when choosing how to allocate your assets.
This is how well you can afford to lose money. It is, in some senses, the counterpart to financial goals.
Risk tolerance is the tradeoff you make between pursuing higher gains at the expense of potential losses, up to and include total. While related to pursuit of gains, risk tolerance is chiefly about your aversion to loss.
Aggressive investors accept a higher chance of loss in exchange for greater potential gains. More conservative investors accept lower potential gains in exchange for a reduced chance of losses.
Risk tolerance is related to both financial goals and time horizon. Your time horizon significantly influences your tolerance for risk, since time lets you make up potential losses, while goals determine the minimum gains you can accept.
Allocation means selecting the best categories of investment for your portfolio, and how to spread your money among those categories. The major categories you can select from include:
- Cash/Cashlike - Keeping your money in cash means bank accounts, certificates of deposit and similar products. While generally the most secure and accessible place you can keep your money, this is also the most low yield.
- Bonds - This includes products like Treasury bonds, municipal debt and corporate debt. As a general rule bonds trade guaranteed returns against yield and accessibility. Government bonds come with virtual certainty of repayment while corporate bonds, despite their security, are rated based on likelihood of payment. However, yields are low and repayment windows are fixed.
- Stocks - Stocks are shares of corporate ownership. These are highly liquid and can repay the investor both through capital gains (profit from selling the stock) and dividends (payments from the underlying entity to shareholders). Gains and losses from stocks can fluctuate wildly. A successful investor can realize significant gains, while a failed stock can zero out. For the ordinary investor this is the highest performing/highest risk section of their portfolio.
- Commodities - Commodities are a more sophisticated form of investment. This asset class involves ownership of raw physical goods such as oil, timber and grain. They are typically traded through options and futures contracts. A commodity investment is typically moderately liquid with the potential for extreme gains and extreme losses.
- Personal and Real Property - This asset class covers virtually all physical property, from gold bars and old comic books to a single family home. This involves purchasing and holding a piece of property in the anticipation that it will accrue value before selling it. Liquidity depends entirely on the specific property in question.
Related to goals, time horizon is how long you anticipate keeping your money in a particular asset class. The major factors in time horizon include risk tolerance and liquidity. An investor with a long time horizon can tolerate more risk in her investment, as she has more time to recover lost money from a down market. For example, a 25-year-old investing toward retirement can choose far more volatile assets than a 55-year-old.
Time horizon also dictates how long your money can stay in a given investment. If you plan on buying new assets, or will need to pull your money out of the market altogether, you should consider carefully before investing in products such as bonds or mutual funds that lock funds up for a specific duration.
How you spread your assets, and which specific products you choose within each category, will be determined by these four issues. Investors with longer time horizons and a greater appetite for risk may invest more heavily into stocks, with an emphasis on young firms that have boom-or-bust potential. Others looking to save money for a child's college education may have a long horizon but a far lower appetite for risk, and could accordingly invest in a mix of conservative stocks and 10 year bonds.
Investors with an eye toward retirement might want to sink a significant amount of money into their house, a highly illiquid asset for a young family but one which retirees often sell.
The specific mix depends entirely on your personal profile.
Beyond the basics, there are a few specific subjects to consider while you determine your asset allocation.
Funds are a way of buying pre-allocated, professionally managed assets. The most common example is the mutual fund, a selection of stocks typically overseen by a firm. However, a fund can invest in virtually any category of assets.
Typically, investors choose funds as a way of risk mitigation. While a fund will never perform as well as the best performing product it owns, losses are typically mitigated by a basket of products whose gains offset individual performance.
Many funds are organized by investment type, technology stocks or precious metals for example. Others will be organized around certain risk tolerances or time horizons. As an investor it's often possible to identify your key metrics and then search out a fund designed around your specific needs.
A specific form of fund built around asset allocation, the lifecycle fund offers a pre-built portfolio built around goal and time horizon. The fund is then reallocated as you approach the year in which you'll need the money.
So, for example, a parent investing toward college education could purchase an 18-year life cycle fund at their child's birth. The fund would start aggressive, and would grow steadily more conservative as high school graduation approached.
100 Minus Your Age
Most investment decisions revolve around retirement. For the average American, this is the finish line of investment. Your portfolio will be the nest egg you need to live on once you can't keep working.
To that end, advisers have the 100 Rule: Subtract your age from 100. That's the percent of your portfolio you should have in stocks.
So, if you're 25, then this rule suggests that 75% of your portfolio should be in stocks. (At least, among those recent graduates for whom investment advice isn't a bad joke.) An often published, more aggressive, version of this rule suggests that this allocation should be 110 minus your age.
This rule of thumb helps many investors figure out their proper risk management approach to retirement. While it isn't necessarily the right advice for everyone, it has a core of basic wisdom: Saving for retirement requires an enormous amount of money, more than many investors realize. If the industry rule of thumb suggests that you should still have half of your portfolio in a high risk/high reward asset class by age 50, that tells you something about just what it will take to retire.
What Is Rebalancing?
Rebalancing is the practice of restoring your intended asset allocation.
As time goes on your portfolio will change its own asset allocation as some sections outperform others. This is particularly likely in a portfolio with highly conservative elements. For example, take an investor who has placed half of his assets into stocks and half into bonds. Even during normal market performance his stocks will grow faster than his bonds. Eventually he will reach a 60/40 split in favor of stocks.
At this point the investor should rebalance, selling some stocks and buying more bonds in order to bring his portfolio back toward its original vision.
While rebalancing often may require you to sell high performing sections of your portfolio in favor of weaker categories, it serves a long term purpose. Rebalancing allows you to set risk mitigation back in place. Even though a section of your portfolio may have done well recently, that's no guarantee it will continue to do so.
Selling those stocks and buying bonds might be painful now, but it will be brilliant in hindsight if the market tanks.
Allocation vs. Diversification
Finally, as we note above, asset allocation and portfolio diversification overlap in many key ways.
They are not, however, the same.
Diversification is the practice of spreading your portfolio among a wide range of assets in order to prevent risk. A well diversified portfolio is built specifically so that it isn't overly exposed to any one section of the market. You want to make sure that if tech stocks crash, you have some money in retail stocks. If the stock market crashes, you have some money in bonds.
While investors use asset allocation as a means of diversification, ultimately asset allocation is about meeting your goals. A well-allocated portfolio is likely a well-diversified portfolio, but not necessarily. A young investor with a high appetite for risk, for example, may have most of her money in high-risk stocks or cryptocurrency. An older investor may have shifted most of his assets to market indexed mutual funds.
In neither case would their portfolio be considered diverse, but in both cases it would probably meet that investor's needs - which is the hallmark of a well allocated portfolio.