Asset Allocation 101, Part 1
Asset allocation can help smooth the extremes of portfolio volatility, making returns more predictable by utilizing different asset classes.
The financial services industry has done a great job of confusing just about everyone. There are no less than a million TLAs (three letter acronyms), not to mention thousands of research papers and enough noise from talking heads to make your own head spin. In previous series, we discussed basic investing and financial planning. Now we are going to build up the foundation of your financial literacy house a bit more and discuss asset allocation.
Why is asset allocation important?
Good question. Thanks for asking. It is important to understand why you should keep paying attention before learning about something. According to a 2010 research article from Morningstar (the premier research firm in the industry), nearly 100 percent of return levels come from asset allocation. Even after accounting for general market movements, the study determined that about half of return variations come from asset allocation decisions and about half come from how they are managed.
What does all that mean? Long story short, research shows that asset allocation has a significant impact on long-term returns.
What is asset allocation?
To start, asset allocation is a term mainly used by financial advisors. Often times, we make the mistake of assuming you understand what it means. Then we describe it by saying it is how you allocate your assets. (Um… rrrriiiiigggghhhhttttt… thanks for clearing that up.)
Asset allocation is simply the mix of your investments as they relate to your total portfolio. My grad school professor will roll his eyes when I say this, but the easiest way to think about it is with a pie chart. My professor hated pie charts, but in this case, it works. Your overall portfolio is the pie. Each of your investments – or assets (cash, bonds, stocks, funds…) – represents a piece of the pie, or an allocation.
Having a mix of various investments is a way to diversify your portfolio to ensure that you don’t have all your eggs in one basket. When done properly, it should give you exposure to a variety of industries and sizes of companies – some more conservative, and some more aggressive. At the end of the day, nobody knows which asset class inside which industry is going to perform best next year, over the next five years, or the next 10 years. Diversification helps reduce your risk by spreading your investments out, but still provides exposure to growth potential.
Ideally you would have a strategy to how you plan to allocate your assets based on your risk tolerance, time horizon, and goals. Finding the right mix for you between safer and riskier investments will help you (and your advisor) come up with a plan to achieve your goals. Everyone is different. What your neighbor does for his or her allocation should not impact how you allocate your investments. The ultimate goal is to minimize the impact of down markets and still participate in the upside.
It is also important to periodically keep up with your investment mix to ensure it is on track with your risk tolerance and goals, while still aligning with your strategy. Over time, allocations can drift from their targets, as investments will gain (and lose) at different rates. When you reallocate your investments to the target mix, it is called rebalancing.
What are some common asset allocation strategies?
It seems as though every time I turn around, there is an infomercial for the next great “sure-thing” investment strategy that will make me rich this afternoon. It can be mine for just $1999.99 if I order today! (Pause while Nick orders multiple copies.) I plan to invest the money I get from my long-lost cousin, the Nigerian prince.
What?! Dang! Those weren’t good strategies at all! I digress. Back to common (and real) asset allocation strategies…
There are a lot of different strategies out there. Picking the right one for you comes down to your personality, how involved you want to be, and finding a good advisor to guide you. The most common asset allocation strategies are:
- Strategic asset allocation – This is a long-term approach that balances risk and reward. Boring, but pretty effective. More passive. Doesn’t change philosophy based on economic changes.
- Dynamic asset allocation – While similar to strategic asset allocation, this strategy changes with economic conditions.
- Tactical asset allocation – This is a more active approach. It is constantly evaluating positions and moving in and out based on what is believed to have the most short- or long-term potential. Use caution here. If you were really as good of a day trader as you think, you’d be managing a $5 billion hedge fund from your yacht in the Caymans.
- Core-satellite asset allocation – This is a hybrid approach. There is a core strategic element that makes up the foundation of the portfolio with satellite tactical approaches to fill it out.
We will go into more detail about various asset allocation strategies in part two of our asset allocation 101 series. Remember, just because your neighbor is investing a certain way doesn’t mean it is a good fit for you. For now, hopefully you at least have an understanding of what asset allocation is and why it is important.