There is a good chance if you’ve looked into investing, you’ve heard the terms asset allocation and diversification. With most industry jargon, you may have heard the terms, but it’s possible you don’t fully comprehend what they mean. And if you don’t understand what they mean, how do you determine what is right for you? Before diving into what is right for you, let’s first address the two terms.
What is Asset Allocation?
At its core, asset allocation is the mix of stocks, bonds, and cash someone has invested. The purpose of asset allocation is the calculated effort to spread out the risk of your investable assets, while aligning the investments to your tolerance for risk and time horizon. Additionally, each asset class has a different amount of risk associated to it and by allocating a percentage of your money into each, you can feasibly reduce your overall portfolio risk. In oversimplified terms, stocks carry more risks than bonds and cash and bonds carry more risk than cash. In practice, an investor with a high tolerance for risk will have a larger allocation to stock in relation to bonds and cash within their portfolio. As you move down the sliding scale of risk tolerance, you will reduce the amount of stock and increase your bond and cash weightings.
What is Diversification?
Diversification can be summed up with the old adage “don’t put all your eggs in one basket”. The primary goal is to level out the unsystematic risk within a portfolio so that when some investments have positive returns, other investments that may have negative returns can be less impactful on overall performance. Diversification takes asset allocation a few steps further. Instead of looking at stocks, bonds and cash as singular investments, it’s the process of determining which stocks or bonds to own. For example, it could be owning a Blue Chip stock versus a speculative stock or a U.S treasury bond versus a corporate bond. In a future blog, I will discuss the importance of diversification and why it matters.
What’s The Right Asset Allocation For You?
If you were to google “what’s the right asset allocation for me” you will get somewhere around 37 million results. Spoiler alert, I haven’t, nor has anyone else, read through all of the results. The most common practices I’ve seen to determin an investors asset allocation are discussed below.
A Standard Risk Tolerance Questionnaire
If you’ve worked with a financial advisor in the past, you may have filled out a risk tolerance questionnaire. The questionnaires are usually quantitative and qualitative in nature. The quantitative or measurable questions are generally “How long do you plan to have your money invested” and “what’s your time horizon for the money”. Then the qualitative or subjective questions are often times, “Imagine that in the past three months, the overall stock market lost 25% of its value. What would you do?” or there will be a question with a chart like this; “We’ve outlined the most likely best-case and worst-case annual returns of four hypothetical investment plans. Which range of possible outcomes is most acceptable to you? The figures are hypothetical and do not represent the performance of any particular investment.”
You end up answering all of the questions on the questionnaire, tally the points, and you have your risk tolerance. From there, the advisor will help align your risk tolerance to the prescribed asset allocation and build a diversified portfolio for you.
100 – Your Age
An old rule of thumb was to subtract your age from 100. The idea is your asset allocation should change every year based on your age while using a life expectancy of 100. As an example, if you are 35 years old, you would subtract your age, 35, from 100. You result would be 65. You would then allocate 65 percent of your money to equites and 35 percent to bonds. There are problems with this rule of thumb, just like most rules of thumb, they aren’t a one size fits all concept. People are living longer, it’s assuming every investor at a specific age has the same tolerance for risk, investment time horizon, and the list goes on.
The New Waze of Questionnires
In the last few years, financial planning firms have started using a purely quantitative questionnaire over the standard qualitative/quantitative assessment that’s been around for decades. As an example, my firm uses Riskalyze to understand our client’s appetite for risk. Their unique approach takes subjectivity out of the risk tolerance equation. What I really like, the results take an ambiguous result from the standard risk tolerance questionnaire and put them into concepts anyone can understand, a speed limit sign. Curious to see how it works? Find out here
One of the most important factors of asset allocation is time horizon or how long will the money be invested before withdrawing it? This may sound obvious, but the shorter the time horizon, the more conservatively the money should be invested. It’s not uncommon to have accounts with different time horizons and different asset allocation strategies. Using the bucket strategy, you may have short, intermediate and long-term accounts. With each account, you may have a different risk profile and ultimately a different mix of stocks, bonds and cash in each.
Common Fears & Pitfalls
Lack of Trust in The Market
Investing can be a bumpy road. Look no further than the end of 2018. From Jan 2nd – Oct 1st of 2018 the S&P500 was up just shy of 8.5%. From Oct 1st – Dec 27th of 2018 the S&P500 was down just shy of 15%. In addition, many millennials were at their first job and just started investing during one of the biggest downturns in market history. Millennials have seen some difficult markets in their short adult lives, it’s understandable why they are skeptical.
Holding too Much Cash
A little as a year ago, only 1 in 5 millennials said the stock market is the best place to have their money for the next 10 years. In another survey, it was found that millennials keep 65% of their assets in cash. While the last of trust in the stock market is understandable, foregoing potential investment returns in the interest of safety simply won’t deliver the returns needed for the majority of Americans. Regardless of their future goals. The average savings account rate at the time of this writing is .1%. It will take 720 years for the money in the bank to double. That’s before you factor inflation into the picture. With inflation, you’re now looking at a negative real return on your savings.
Target Date Funds
If you are unfamiliar with target date funds, you pick a date at some point in the future as you time horizon, generally when you plan to retire, and the asset allocation of the fund is determined by that date. The longer the time horizon the more stock. While this type of investing works for some, the money isn’t invested based on your risk tolerance. Target date funds are more of a “rule of thumb” way to invest your money. Is this the worst thing you could do money? Absolutely not. That said, your money should be invested based on what’s appropriate for you, not what’s appropriate for the masses.
There is no one size fits all when it comes to asset allocation. It shouldn’t be based purely on age, investment size, or time horizon. Instead, it should be specific to you, your goals and your appetite for risk. Having a conversation with a financial advisor about your tolerance for risk and completing a risk tolerance questionnaire are crucial steps to take before investing a dollar of your money.