Asset allocation is a nice alliteration. But what does it mean for an individual investor. At first, I thought it was just about how much bonds do you need…
As I am maturing in investing, I start to understand more and more the value and power of asset allocation. Once understood, it can make your life so more simple.
What is asset allocation?
Asset allocation is the break down (allocation) of your investments (assets) into different categories and sub categories.
The categories could be
- precious metals
- real estate
- Insurance products
Understanding what each asset class can mean for your financial plan is important. Each class has certain risk and return characteristics. You can learn about these by looking at the data of the past. It gives a good indication, but it is no guarantee.
Why does asset allocation matters?
With an asset allocation, you can pick a risk that is comfortable for you. Risk can be understood as different things: why not the maximum paper loss. For most people this is important as they have a hard time to see paper loss – they do not like that their broker account shows that today they have a loss. But remember, this is only a loss if you sell all on that day.
How does this work?
Some assets are less risky than others. It means that you have historically less losses in a market crash in that asset. A good example is Bonds vs Stock. I case of a crash, bonds will loose way less than stocks. In the long long term, stocks have the potential to generate a higher return. You often read that US stocks in the long run generate a return of about 7pct (after inflation). In some years, it will be even more, lets say 20 pct. In bad years, it can be -32 pct. This is the result of the higher volatility that stock have.
Assets classes can move in different directions and with different speeds. One asset class can go up while the other one goes down. A classical example our stocks and bonds. It is not uncommon for bonds to stay steady or to go up if stocks go down.
Mixing bonds and stocks together brings you less risk. There is a whole theory and academic studies behind this idea. It involves a lot of math. Just look at the historical returns of some sample portfolios in books like the intelligent asset allocator and you see the theory in action.
One thing to know: If you adjust your risk, you are also adjusting your potential return. A general rule is that lower risk means lower potential return: there is no free lunch.
What is your asset allocation?
How do you find your asset allocation? How much bonds and stocks do you need? Not an easy question. It depends on a lot of factors.
- How much risk do you need to take?
What is the start capital that you have and how much will you invest regularly. Then, look the goal you want to achieve: how much you need? With some financial math, you can derive from that the yearly return you should have. Please think about this number. If it is unrealistically high (anything above 7pct) then you are better off in a casino I think. It is not likely to get a long term sustainable return that is higher than the historical average. Unless you are the next Warren Buffet.
- How much risk can you take?
Here you need to look at parameters like your time horizon (the shorter the time horizon, the lesser risk you should take), the size of your emergency fund (do you need the invested funds in case of an emergency?), your current situation (stable income, will your personal situation change over time,…).
- How much risk are you willing to take?
This is the “will you sleep at night” question. How will you feel if there is a market crash. Will you be able to stick to the plan? Will emotions take over?
Another element that plays here is the consequence of not reaching your target. What options do you have? Is it bad if you need to wait a few years before reaching your goal? For some people, investing for their old timer is a long shot. If the markets are nice, it will be a unique piece, if it goes slower than planned, they can either wait a few years or are happy with another car.
Some guidance to help you
There are many rule of thumbs out there that can help you to define your asset allocation
- Age based
The rule is that you have your age in bonds. Or, you have 100-your age in stocks. The idea is here that you are less willing and able to take risk if you get older. If you think and feel you can take on more risk, then you use not 100 but 110 or 120 as a starting point.
If you are already in retirement, you probably don’t want to take a lot of risk with your nest egg, you also have less the need for risk. If all is well, you are happy to see your nest egg beat the inflation. When you are young, you have plenty of time to recover from a crash. you are still building up your wealth, so you are willing to take the risk and adjust later down the road.
- Time horizon based (Rule from Larry Swedroe)
This method looks at the time left for your specific investment goal. If you have a lot of time left, you can take on more risk, as you have more time to recover. If the goal comes closer, then you lower the risk (lower the amount of stock in your portfolio)
Some guidance that is often given is to have 100 pct equity if the horizon is 20 years or more. It would drop to reach 20 pct if you have 5 years horizon. For the remaining last 3 years, you go down to 10pct and then to 0.
|Investment horizon||Max equity allocation|
- Maximum loss based (Rule from Larry Swedroe)
This rule is based around one axe: how much risk are you willing to take. It looks at the expected loss of a certain asset allocation. Do you want to see a max loss of 15pct, the go with 40pct equity. This is of course a rule of thumb, in a real crash like in 2008, you could end up loosing more than stated here.
|Max loss you’ll tolerate||Max equity allocation|
The right answer
The challenge with asset allocation is the following: there is no perfect asset allocation. The future is uncertain. People tend to overestimate their risk tolerance when the markets go up. The reason: they do not want to miss out on the party. This could lead to an over exposure to equity. Next to that, our goals will also change over the course of the years, so a change in the asset allocation will be needed.
Personally, I have put in place some safety nets like an emergency fund and cash for medium term expenses. With these buffers, I hope to leave the paper loss as a paper loss (meaning: not needing to sell when I am in need of cash). I added extra safety by investing in capital guaranteed products. For now, I can do 100pct of my additional investments into stocks. I only have to review my position when I reach a balance of approx 50/50.
Is there a downside? Yes! I miss out some of the great returns of 2014 and 2015. But at least, I do not have to worry about what if scenarios: what if I need cash and the markets are all time low and I have a paper loss of 45pct.
It is important to understand your own situation and your own goals. Once this is clear, finding the right balance will be so much easier.
How do you deal with the asset allocation challenge?