Today I will be looking at the importance of asset allocation to your portfolio and why it is an important part of any investment strategy.
What is asset allocation?
Asset allocation is an investment strategy that assists in balancing your risk versus reward by building a diverse portfolio of different asset classes. The allocation will vary based on your individual circumstances, risk level and investment timeframe.
In a previous post Index Funds The Foundation of Your Investment Portfolio I covered the benefits of using Index Funds one of those being diversification.
An asset class is a bundle of assets based on specific criteria. Traditional assets are Stocks, Bonds and Cash. These classes can be broken down further as follows:
- Stocks – large, mid, small and micro-cap. growth, value and dividend. domestic, foreign and emerging markets.
- Bonds – government or corporate. Investment grade, high-yield(junk). long-term, intermediate and short-term. domestic, foreign and emerging markets.
- Cash – deposit, term and money market.
Alternative Asset Classes
- Realestate – commercial or residential including REITs
- Commodities – precious metals and agricultural
- Insurance products – life insurance, annuity, catastrophe bonds
- Collectables – coins, stamps, art, antiques
- Other – derivatives, options, futures, foreign currency, venture capital.
Not all asset classes perform the same. Some have more volatility but potentially higher returns such as emerging markets. Others have low volatility and lower returns such as cash. Below is a graph of Asset returns over time from Vanguard.
The goal of asset allocation is to give you a smoother and more consistent investment return. One of the biggest mistakes investors make is selling investments in a bear market due to fear. This is why asset allocation is important as it can be tailored to your own level of risk tolerance.
Basics of Asset Allocation
The first and most critical step of determining your asset allocation strategy is determining your stock to bond ratio. Below are 4 typical ratio’s
- Ultra Aggressive – 100% stocks: If you are aiming for the highest long term returns and can handle very large fluctuations in the short term.
- High Growth – 80% stocks, 20% bonds: If you are aiming for strong long term returns and can handle large fluctuations in the short term.
- Balanced – 60% stocks, 40% bonds: If you are aiming for medium long term returns and can handle medium fluctuations in the short term.
- Conservative – less than 50% stocks: If you are aiming for capital stability and less risk of large fluctuations in the short term.
The goal of an allocation ratio is to maximise returns while keeping the portfolio from exceeding a certain level of volatility, or risk. The ratio will change as you go through life. This is especially true when transitioning from accumulation phase to drawdown phase when entering retirement.
What if you had a 80/20 stock to bond split and the value of the stocks go up? This will increase the stock percentage and decrease the bond percentage putting your allocation out of balance. In this case you would sell some stocks and purchase some bonds to get back to the 80/20 allocation. This rebalancing makes you take profits from the asset classes that are out performing and purchase asset classes that are on sale.
It is generally recommended to rebalance your portfolio once a year or whenever you have an asset class that gets more than 5 percent outside its allocation.
TIP: You can also use additional contributions and dividend income to purchase the under allocated asset classes to avoid triggering a sell event.
The hardest thing of all is sticking to your investment strategy. This quite often this means selling an asset class that is doing well to purchasing one that is doing poorly.
I would like to hear about your asset allocation and the logic behind it. How did you go in the last bear market in regards to sticking to your allocation? Feel free to leave a comment below or hit me up on my Contact page.