Asset allocation describes how an investor distributes their investments among various classes of investment options (e.g., stocks and bonds). Most successful investors will tell you that asset allocation is the most important decision you make in determining how well your portfolio performs. As noted in my recent article Charlie Munger’s 10 Rules for Investment Success, he pointed out “Allocate assets wisely: Proper allocation of capital is an investor’s No. 1 job.”
The conceptual foundation of asset allocation is the premise that the best-performing asset(s) will vary from year-to-year and is not easily predictable. By spreading your investments across various asset classes, some will be over-performing while under-performing – Don’t put all your eggs in one basket. With fixed percentages on each of the asset classes you reallocate out of the better performing assets into the under-performing assets – Buy Low, Sell High.
Examples of asset allocation classes include, by asset type: Cash, Bonds, Stocks, Real Estate, Currencies, Natural Resources, Precious Metals, Collectibles, etc.
When looking at equities they can be sub-divided into additional asset classes grouped by:
- Size such as: Large-Cap, Mid-Cap and Small-Cap
- Style such as: Growth, Blend and Value
- Sector such as: Financial, Consumer, Industrial, Health-care, etc.
- Other such as: REITS, International, Emerging Markets, Life Settlements
Individuals determine which mix of assets to hold in their portfolio based largely on their time horizon and ability to tolerate risk. Time horizon is the expected period of time (months, years, or decades) you will be investing to achieve a particular financial goal. Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. When it comes to investing, risk and reward are often directly related. Over 20 years you will likely not lose any money investing in a federally insured money market account (MMA), but you will likely earn less than you would in an S&P index fund. Though in any given year the index fund could lose money, and over the 20 years will likely have several years in which it loses money – No pain, no gain.
There are a lot of tools available on the web to help you determine your asset allocation. Here are three, one very simple and the other two a little more comprehensive:
Once your asset allocation is set, it is not changed often. The most common reason for changing your asset allocation is a change in your time horizon. As you approach your investment goal, such as retirement, you may want to reevaluate your risk profile. It is important to note that savvy investors typically do not change their asset allocation based on the relative performance of asset categories.
As described in my article “Process Overview and Asset Allocation“, I currently allocate assets broadly by the type of investment (mutual funds, ETFs, dividend stocks) with some attention given to sectors within my dividend stocks. I am currently working on refining my process and will discuss this in future posts.
If you are interested in learning more about asset allocation, The U.S. Securities and Exchange Commission (SEC) has a good primer on asset allocation titled “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing“.