“If you have trouble imaging a 20% loss in the stock market, you shouldn’t be in stocks.” -– Jack Bogle, founder of Vanguard.
If you invest 100% of your money in stocks, and the stock market has a bad year (or ten), you lose money. That’s why asset allocation is one of the most important investing concepts even though it’s so often ignored by everyday investors.
If you want to learn how to create an investment portfolio that grows year after year, you must master this essential art.
Note from David before we get started: Every time we post about investing, I get mixed feedback. I hear from people who want to know more about individual funds and advanced topics, and I get very basic questions, like what’s the difference between an individual retirement account (IRA) and a regular brokerage account.
Answer: IRAs have tax perks to encourage you to save for retirement, but have limits to how much you can invest each year and restrictions on when you can withdraw your money. In a regular brokerage account, you can invest and withdraw money as you please, but you’ll pay taxes on your gains. Those differences aside, whether an account is an IRA or not, choosing investments is the same. An IRA or an investment account is simply a bucket that you fill with many different investments.
To intermediate and advanced investors, it may seem silly to explain this, but believe me, many many people are totally confused by this distinction.
Because I started this blog for people who are new to learning (or re-learning) personal finance and my goal is to keep explanations as simple as possible, I focus investing content on the fundamentals. If we ever repeat ourselves, it’s only because I want to drive home the big, important concepts that, when followed by ordinary people (especially from a young age), make ordinary people wealthy. If you want to get into stock picking, options trading, and forex markets, more power to you, but here, we’ll stick to basics.
If you’ve gotten your feet wet investing, you’re probably at least aware of the three major asset classes: stocks, bonds and cash. Moving beyond these common asset types, however, and you could invest in real estate, private equity, natural resources, foreign currencies, and more.
These are examples of asset classes, and the list is endless.
BUT WHAT IS ASSET ALLOCATION?
Asset allocation is about choosing how much to invest in each asset class.
It doesn’t matter if your investment account is an IRA, 401(k) or 403(b), or a regular brokerage account, asset allocation works for any portfolio.
The Grocery Basket Analogy
Here is an analogy that explains exactly how asset allocation works:
When you go to your local grocery store, you grab a shopping basket. The basket is where you place all the items you are going to purchase. You put cereal, milk, soup, steak, juice, pasta, ice cream, and anything else into your basket.
The quantity of items you put into your basket is based upon your wants and needs. Asset allocation works exactly the same way.
Your retirement account or investment portfolio is the grocery basket. The food items that you selected are different asset classes. You can select from amongst different stocks, bonds, mutual funds, exchange traded funds, Treasuries, and money market accounts. Your portfolio mixture is determined by your investment goals (based upon your wants and your needs).
The objective of asset allocation is to broadly diversify your investment portfolio, just like you probably diversify your diet. (Even if you love cheeseburgers, you don’t want to eat them all the time because you’ll miss out on nutrients in other foods.)
In investing, you never want to be overly invested in one asset class and you want to avoid investing in assets of poor quality. The goal of proper asset allocation is to provide the ideal mix of investments that gets you the greatest long term gains for a minimal amount of risk.
How You Should Allocate Your Portfolio
There are a number of factors to consider when determining proper asset allocation. For example, I advise clients to break investments up based on their age, risk tolerance, years to retirement, and goals.
The portfolios of two 26 year-old employees can be dramatically different due to risk tolerance. For example:
- Is a risk taker who wants maximum exposure to the stock market.
- Figures that whatever money he loses now, he’ll have the time to make back.
- As a result, invests his portfolio 75% or more stocks.
- Is much less of a risk taker.
- Focuses primarily on capital preservation.
- As a result, invests only 50% of his assets in stocks and place the rest in bonds or cash.
Of course, age is not the sole factor when making investing decisions. A 26 year-old millionaire may care a whole lot more about preserving capital than a 26 year-old starting out with a $10,000 401(k) that she wants to grow as quickly as possible.
Cases like these are normally the exception rather than the norm. On average, the younger you are, the more heavily you should invest in stocks. (This could be in individual stocks, stock mutual funds, or index funds.)
All of these methods give an investor access to the market. A person in her twenties may devote 80% of her portfolio to stocks, whereas a retiree may have less than 20% of his overall portfolio in stocks (primarily because, in retirement, he’s relying upon his nest egg for annual income and can’t afford losses).
Source: Smart Money
Put another way, the longer the time period that you have to invest, the larger the growth you should expect from your portfolio (and the more stocks need to be a part of it).
My Asset Allocation Strategy
I have personally found that a strategy of investing primarily in common stocks works well for me. I am an aggressive investor who enjoys taking on plenty of risk as long as the potential reward is worth it. I prefer to place the bulk of my money in my best investment ideas and less money in just the “good” ideas. This way I am heavily invested in the stocks that I believe in the most. In fact, one of my biggest regrets was not pouring enough money into several big name stocks that were trading at ridiculous valuations during the March lows of 2009.
I have a limited amount of fixed income investments because I prefer the long term capital appreciation that stocks offer. I figure that I have enough time to outlast any substantial dips in the market. For this reason, my portfolio is 90% concentrated in equities because this strategy has been, and continues to be, effective for me.
Although this configuration works well for me, it’s definitely not something that I would recommend to any of my investment clients. I take a more balanced approach with client’s funds because their investing goals and risk tolerances are substantially different than mine. I learned a long time ago that there is no such thing as a perfect portfolio. The closest thing to perfection is to pick an asset allocation strategy that you feel is tailor-made for you.
Why Asset Allocation Matters
The goal of asset allocation is to eliminate risk as much as possible.
There will, of course, always be market risk…the risk that an entire market will decline.
(We saw a good example of market risk from the fall of 2008 to the spring of 2009. Every asset class declined across the board. Stocks bonds, mutual funds, and real estate all took a nose dive. Money market funds—considered the safest of safe investments— even lost money.)
Market risk is the risk that comes with any investment. Even savings accounts and United States Treasuries carry the risk that the government could default on them. (Most banks accounts are FDIC insured to $250,000, but even then there is the risk the U.S. Government could become insolvent. The bottom line is that risk, however slight, is everywhere.)
The good news is that with smart investment, you can eliminate many other risks, specific the kind of risk known as unsystematic risk (the risk that lies within a specific investment.)
Investing in any individual stock or bond leaves investors vulnerable to the risk that the particular investment could go down in value. Fortunately, you can eliminate this type of risk by properly diversifying your portfolio. Diversification gives you the opportunity to make money with one asset class even while another declines.
WHAT YOU CAN DO NOW
If you already have an investment portfolio (and yes, an IRA or 401k counts), give your portfolio a checkup. With a free membership to Morningstar, you can “x-ray” your portfolio and save it to see how changes could affect your asset allocation. If you notice, for example, that your portfolio is too heavily weighted in one asset class, you should consider adding investments of another class. Check out recommended mutual funds and ETFs or—if you have an employer-sponsored 401(k) or 403(b), check with your plan administrator for your available investment choices.
SHARE YOUR ALLOCATION
How old are you and what are your investment goals? What’s your asset allocation look like (stocks/bonds/cash/other). Let us know in a comment!