Understand the asset allocation for your portfolio

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Investing in stocks is one of the best ways to build long-term wealth available to ordinary Americans. Despite the long term benefits, investing in stocks comes with several risks that make it a bad idea to keep 100% of your money invested in stocks throughout your life. Same Warren Buffett – arguably the greatest stock investor of our time – doesn’t put all of its money in stocks.

This is where asset allocation comes in. This investment strategy aims to balance risk and return by allocating part of an investor’s portfolio to less risky asset classes to offset the risk associated with more volatile assets such as ordinary actions.

This guide will help investors understand the importance of asset allocation and which factors play the most crucial roles in determining the best mix of assets for each investor.

Image source: Getty Images.

What does asset allocation mean and why is it important?

Asset allocation is an investment strategy that divides an investment portfolio between different asset classes. This process creates a diverse mix of assets designed to offset riskier assets with less risky assets. Asset allocation is often deeply personal as it largely depends on the investor’s ability to tolerate risk and their time horizon for investment.

Asset allocation is the main driver of volatility encountered by an investor and the returns he obtains. According to a Vanguard study, 88% of an investor’s experience is linked to asset allocation if they have a diversified portfolio, not the specific stocks they own in that portfolio.

In other words, investors with the same asset allocation generally had consistent experiences even though they held different investments. This is mainly due to the correlation between assets of the same category, which means that they generally move in the same direction. Given the importance of asset allocation, investors need to find the right mix that matches their risk tolerance and time horizon.

As an example, let’s take a look at two hypothetical investors. One is single, 25 years old, with no children and a stable career. The other is a 65-year-old married man who has just retired.

The first investor has a long investment horizon since he is decades away from retirement, while the other has a shorter one since he is already there. Meanwhile, since the first hypothetical investor does not yet have a family but has a stable job, they can afford to take more investment risks, while the other is likely to want to play it safe.

So their asset allocations are likely to be very different. The first investor can afford to keep more of their portfolio in riskier assets. Meanwhile, the recent retiree will likely want a larger percentage of his portfolio in less risky investments because he has less time to make up for bad investments.

Types of assets

There are three main categories of investment assets:

  1. Actions: Stocks give an investor a stake or ownership right in a company. Equity investments include ordinary shares, preferred stock, mutual fund, and exchange-traded funds (AND F). These equity investments could generate dividend income or could be non-dividend payers such as growth stocks.
  2. Fixed income: Fixed income investments are debt securities and debt-like investments in a business or government entity or a loan to an individual. Fixed income investments include corporate bonds, municipal bonds, and treasury bonds. They can also be mortgages, bridging loans, personal loans and other debt-like instruments with a fixed rate income payment.
  3. Cash and equivalents: Cash and equivalents include cash, savings accounts, money market accounts, and bank CDs.

Besides to these three main asset classes, there are several other types of investable assets. These include real estate (rental properties, agricultural land and commercial real estate), commodities As gold, futures and other financial derivatives such as options, and crypto-currencies.

Asset allocation

Portfolio diversification is a measure taken by investors to reduce their risk of incurring a permanent loss or experiencing extreme volatility. Asset allocation goes even further by introducing less risky and less volatile assets, such as fixed income securities. For example, here’s how increasing an investor’s allocation to fixed income securities can impact the volatility and overall returns of their portfolio:

Asset allocation

Average annual return

Best year

Worst year

Years with a loss

100% shares

10.2%

54.2%

-43.1%

25 of 94

80% equities and 20% bonds

9.7%

45.4%

-34.9%

24 of 94

70% equities and 30% bonds

9.4%

41.1%

-30.7%

23 of 94

60% equities and 40% bonds

9%

36.7%

-26.6%

22 of 94

50% equities and 50% bonds

8.6%

33.5%

-22.5%

20 of 94

40% equities and 60% bonds

8.1%

35.9%

-18.4%

19 of 94

30% equities and 70% bonds

7.7%

38.3%

-14.2%

18 of 94

20% equities and 80% bonds

7.1%

40.7%

-10.1%

16 of 94

100% bonds

6%

45.5%

-8.1%

19 of 94

The data source: Avant-garde. Data returned from 1926 to 2019.

As can be seen from the table, a portfolio composed of 100% equities generated the highest average annual return compared to portfolios with some allocation to fixed income securities. It also produced the best overall year. However, this hypothetical portfolio also suffered the most years with losses and the largest loss over a year.

As investors increased their allocation to fixed income securities – bonds, in this case – they reduced their overall average annualized return. However, they also reduced the risk, as evidenced by lower losses in the worst year and fewer years with losses. Higher allocations to bonds generated higher year-over-year returns than a more balanced portfolio. At the same time, a 100% bond allocation resulted in more years of losses than some more balanced portfolios.

Adding other asset classes to a portfolio can further reduce its overall volatility while improving returns. For example, a traditionally balanced portfolio (60% stocks and 40% bonds) has produced an average annual return of 8.15% over the past 30 years.

This wallet had a standard deviation (an annualized volatility calculation) of 10.68% and a Sharpness ratio (a risk rating based on the volatility of a portfolio’s returns for a risk-free asset like short-term treasury bills) of 0.76.

However, adding 10% allocations to real estate and farmland while reducing allocations of equities and fixed income securities to 48% and 32%, respectively, resulted in a more total return. high (8.46%) with less volatility (8.62% standard deviation) and less risk (0.98 Sharpe ratio) during this period.

Four hands separating a dollar bill.

Image source: Getty Images.

Asset allocation by risk tolerance

An investor’s risk tolerance, or their ability and willingness to lose all or part of their investment in exchange for the potential for higher returns, is a critical factor in determining asset allocation. Since mixing different asset classes lowers a portfolio’s risk profile, investors with a lower risk tolerance (regardless of age) should consider having a higher allocation to lesser assets. risky such as fixed income and cash.

They might also consider other asset classes less correlated to equity and bond markets, such as real estate and commodities such as gold, to further reduce the risk profile of their portfolio. Conversely, investors with a higher tolerance for risk should weigh their asset allocation more on equities such as common stocks.

Risk tolerance can be a state of mind, as some people are more risk averse than others. Meanwhile, life stage or future planning also plays a role in determining levels of risk tolerance.

A young investor may have an extremely low tolerance for losses, which leads them to have a higher allocation to less risky assets. On the other hand, a more risk-tolerant investor might choose to reduce their exposure to equities and increase their allocations to bonds and cash if they have recently changed their life (got married, lost their job or had a baby). Likewise, it makes sense for an investor to shift their allocation to less risky assets if they plan to use a portion of their investments to fund a significant future expense, such as buying a home, starting a new business, or traveling.

Asset allocation by age

Age is another factor that investors should take into account when establishing their asset allocation strategy. For asset allocation by age, younger investors should consider having a higher allocation to equities, while older investors approaching retirement should increase the percentage of fixed income in their portfolios.

There is no universal asset allocation strategy

Asset allocation plays a vital role in the overall investor experience as there is a strong correlation between assets of the same class. However, there is no standardized asset allocation strategy for all investors.

Instead, an investor should customize their asset mix to ensure they have the right mix of asset classes for their risk tolerance and age. This will improve their investment experience by reducing the overall volatility of their portfolio while producing acceptable returns.


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