Asset Allocation: A Comprehensive Exploration

In the world of investing, asset allocation is a fundamental and indispensable concept. This strategic approach—with the overarching goal of striking a delicate balance between risk and return—exists beyond mere financial strategy as both an art and a science, demanding a nuanced understanding of its intricacies and application. This article will explore the same.

What is asset allocation?

At its core, asset allocation is the definition of the old adage “don’t put all your eggs in one basket.” It’s the process of divvying up an investment portfolio among asset classes (typically stocks, bonds, and cash or cash alternatives) to ultimately create a diversified portfolio well-suited to weather market storms and maximize growth potential.

Why invest in different assets? It’s simple: each asset class boasts its own unique risk and return characteristics and (historically) displays unique market movement (e.g., when stocks go up, bonds typically go down and vice versa). The following generalization reflects characteristics of the three most common asset classes.

Stocks
Stocks, or equities, represent ownership in a company. This asset class historically sees the highest returns of the three but does come with the greatest level of risk, as stock prices are subject to market fluctuations influenced by numerous factors including economic conditions, company performance, and investor sentiment.

Different stock categories based on market capitalization (the total value of company shares) come with varying degrees of risk/return as well. Large-cap stocks are shares of well-established companies with large market capitalizations (exceeding $10 billion) and therefore tend to see more stable prices but may offer slower growth. Mid-cap stocks (with market capitalizations between $2 and $10 billion) belong to mid-sized companies with comparatively mild stability but also mild growth. Finally, small-cap stocks (market capitalizations below $2 billion) represent smaller companies that are often more volatile but have the potential for higher returns.

Bonds
Falling in the middle of the risk spectrum, bonds are debt securities issued by governments, municipalities, and/or corporations that offer periodic interest payments and the return of principal at maturity. Bond prices are influenced by interest rates, carrying market and interest rate risk, and higher-yielding bonds often come with increased credit risk as well—as issuers with lower credit ratings may default on payments.

Cash and Cash Equivalents
Cash and cash equivalents, including physical currency, bank deposits, and short-term, highly liquid investments, are considered the least risky overall: providing safety and liquidity, but returns on cash and equivalents are generally lower.

Risk tolerance and asset allocation

One large reason why no “perfect” asset allocation exists is because different investors have different risk tolerances (defined as one’s ability and willingness to tolerate large swings in investment value); relatedly, each investor requires this money at different times (i.e., his/her “time horizon”). Let’s consider two different investors who might benefit from different asset allocations…

Our first investor is 30 years old. She is investing for retirement (planning to do so at age 65) and therefore has a 35-year time horizon. Our second investor is 59 years old and plans to retire within the next year when he turns 60. They both have the following asset allocation (Stocks: 75%, Bonds: 20%, and Cash: 5%):

Riskier Portfolio

This is considered a fairly risky portfolio given its high proportion of stocks. Now, let’s say a recession suddenly hits. The jury is out regarding how long it will take the market to recover, but since 1920, it’s taken 3.1 years (on average) for the stock market to bounce back and reach pre-recession levels—so let’s go with that number.

Our 30-year-old investor who doesn’t need her investments for decades is perfectly fine; her funds have plenty of time to recover and will likely see many more recessions in the years ahead. Our almost-retiree is not so lucky. His portfolio takes a major hit, leaving him with less money for retirement than he had planned on and thus needing to work two years additional years to make up for the difference.

Perhaps you’re saying to yourself, Why didn’t he have a more conservative portfolio to limit risk? The most likely answer? He didn’t want to miss out on potential returns. Let’s consider another scenario with our same two investors, this time using the following asset allocation for both (Stocks: 20%, Bonds: 75%, and Cash: 5%):

Highly Conservative Portfolio

This is a highly conservative portfolio that will allow the almost-retiree to retire even if an imminent recession hits, as he’d lose much less of his portfolio than he would in the above example even if the stock market takes a dramatic nosedive. For our 30-year-old investor, however, this portfolio can mean missing out on a large sum of potential returns.

Historically, the S&P 500 has seen average annual returns of 10% while the average return on corporate bonds has hovered between 4% and 5% (according to Smartasset.com). Three decades of compounding will only exacerbate this disparity and can mean the difference between retiring at 65, as planned, or enjoying the ability to retire early.

Rebalancing and asset allocation

Rebalancing, for all intents and purposes, falls into one of two buckets: in response to the market and in response to the investor.

Over time, a portfolio’s allocation tends to shift; rebalancing in response to market changes is necessary to adjust back to the intended distribution. For example, let’s say an investor has the following asset allocation: Stocks: 58%, Bonds: 38%, and Cash: 4%.

This is appropriate for this particular investor, but over time, his stocks perform well and grow faster than his bond investments—shifting his portfolio to the following: Stocks: 70%, Bonds: 26%, and Cash: 4%.

This is a riskier portfolio and thus no longer as appropriate, calling for rebalancing to simply make adjustments to bring it back in line with the original asset allocation.

Rebalancing is also necessary when an investor’s risk profile changes, which can occur as he/she approaches retirement and wants to limit risk (as discussed earlier). It can also occur if the investor’s goals change. For example, if a 25-year-old investor is saving for retirement—which is decades away—he can handle a higher level of risk. Five years later at 30, however, he decides to purchase a home within the next few years; the time horizon is now much shorter. The entire portfolio doesn’t necessarily need to feed the goal of a down payment (as he’s ideally working toward multiple financial goals simultaneously), but the previous high-risk portfolio is no longer as appropriate and requires rebalancing.

Asset allocation beyond stocks, bonds, and cash equivalents

While stocks, bonds, and cash equivalents are the most common types of investments, plenty of other asset classes are also in play including:

• Real estate: Properties such as land, residential homes, commercial buildings, and rentals

• Collectibles: Items that often appreciate in value over time including art, antiques, rare coins, and vintage cars

• Cryptocurrencies: Digital or virtual currencies such as Bitcoin, Ethereum, etc.

• Hedge funds: A limited partnership of investors that typically has more flexibility (than, say, a mutual fund) to invest more aggressively to ideally maximize returns

• Derivatives: Contracts based on the value of an underlying asset, group of assets, or benchmark, various types of derivatives include:

• Futures, wherein two parties agree to buy and sell an asset at a set price in the future; commodity producers (e.g., oil, gas, and agriculture companies) and consumers often utilize this option to lock in prices for goods or hedge against potential price fluctuations.

• Forwards, similar to futures and traded over the counter (OTC) rather than on an exchange; OTC markets are less regulated and essentially a lower-tier marketplace for smaller companies (often public outfits not listed on exchanges).

• Options, similar to futures and forwards but non-binding; the party buying the contract is under no obligation to use it, with these often used for stock speculating.

• Swaps, which allow two parties to exchange cash flows or liabilities to help reduce costs or generate profits; these are often used for interest rates, currencies, and credit defaults that gained notoriety during the 2007–2008 financial crisis.

So, how exactly do these less traditional assets fit into a portfolio? Should we consider them with respect to asset allocation? And are more asset classes always better? The short answer to the last question is no, not necessarily.

The goal of asset allocation is to diversify your portfolio to minimize risk and increase returns, and one potential concern with alternative investments is that they often come with more risk (e.g., cryptocurrencies have historically high levels of volatility).

For some investors, the inclusion of higher volatility assets is perhaps appropriate; but this is not the case for others. Another potential concern is liquidity. Investing in many alternative investments means locking up your money—sometimes for years—which is both inconvenient and potentially riskier, as it’s difficult to predict what markets will look like that far down the road and can put you in a bind if you require access to your money. If you already have a strong portfolio of stocks and bonds and believe additional diversification may be appropriate, however, it’s worth discussing alternative investments with your financial advisor.

Key takeaway

Mastering the art and science of asset allocation is an excellent tool to help navigate the complexities of financial markets. By understanding your risk tolerance, embracing diversification, and committing to regular portfolio rebalancing, you can create and maintain an asset allocation to successfully optimize your portfolio.

FAQs

• How often should I rebalance my portfolio?

  Portfolio rebalancing frequency is influenced by various factors such as market conditions, investment goals, and risk tolerance. Some investors opt for an annual rebalancing, while others choose a more dynamic approach. Either which way, regular assessment and adjustment are key to ensuring the portfolio stays aligned with the target allocation.

• Can I use a one-size-fits-all asset allocation strategy?

  Asset allocation is inherently personal, squashing any idea of a universal strategy. As tailoring your asset allocation to your individual risk tolerance, financial goals, and time horizon is paramount, what works for one investor may not be suitable for another: emphasizing the need for a customized approach.

• How does asset allocation evolve with age?

  As investors ride the wave of life, risk tolerance and financial goals fluctuate accordingly. Younger investors, with a longer time horizon, may adopt a more aggressive asset allocation with a higher percentage of stocks. As retirement beckons, however, a shift towards a more conservative allocation with a focus on income-generating assets becomes prudent.

• What is the “100 minus my age” rule?

  A common rule of thumb is that the percentage of stocks in your portfolio should equal “100 minus your age,” with the remainder invested in lower-risk assets such as bonds. Investors in their mid-30s, for example, should allocate 65% of their portfolios to stocks. Of course, there are plenty of reasons why such broad generalizations are sometimes not appropriate; but if you’re age 25 with a portfolio that’s only 25% stocks or age 60 with a portfolio comprising 75% stocks, there better be a very good reason for that allocation.

• Does asset allocation guarantee profits?

  No investment strategy, including asset allocation, can guarantee profits. While this tactic effectively manages risk and optimizes returns, external factors and unforeseen events can impact portfolio performance nonetheless—speaking to the importance of regularly reviewing and adjusting one’s asset allocation based on evolving circumstances to boost the chance of sustained success.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual or business. All investing involves risk, including loss of principal. No strategy assures success or protects against loss.