Asset allocation is the selection of various assets from classes such as cash, fixed income, stocks, real estate and real assets (e.g. commodities, precious metals, and collectibles) to construct an investment portfolio to meet individual investor specific objectives (goals). The asset allocation, or asset “mix,” is different for each investor based on their objectives, and quantitative and qualitative factors. The primary goal of asset allocation is to earn high enough investment returns to meet investor objectives with the least amount of risk possible.
Research by Morningstar and other studies show there is a consistent gap between investor returns and overall market returns. Why is this? Because investors tend to chase performance, by shifting their funds to invest primarily in the asset class that has done the best recently. We call this “performance chasing” and it rarely turns out well. As the Chart below from Callan shows, it is highly unlikely for the same asset class to be the top performing asset class for consecutive years.
How do investors aIM for their Optimal Risk/Return?
Asset allocation achieves optimal risk/return metrics by allocating, diversifying and rebalancing the underlying investments assets within a portfolio. In addition to ADR (allocate, diversify, and rebalance), investor specific quantitative and qualitative data plays a role in the appropriate asset allocation. This blog will explore how age and time-horizon, income & net worth, risk tolerance and capacity, emotions and biases, and objectives all dictate asset allocation.ADR
ADR – Allocate, Diversify, Rebalance
Allocate, diversify, and rebalance – are investing principles all investors, regardless of experience and knowledge, can follow to achieve optimal portfolio returns with the least amount of risk possible. Let’s take a look at each letter in the acronym and why it is an important aspect of investing principles.
Allocation is the weighting of each asset class in an investment portfolio. Allocation can be thought of both in percentage terms (20/80, 60/40 or 90/10), or risk profile (Conservative, Moderate or Aggressive). The 60/40 Moderate portfolio – one of the most, if not the most, common allocations – is 60% stocks and 40% fixed income & cash. A greater allocation to stocks and real estate provides more opportunity for growth and higher potential long-term returns, at the risk of short-term fluctuations and/or losing principal. A higher allocation to cash and fixed income, such as a conservative portfolio, provides more stability of principal and income, while sacrificing long-term growth and exposing the investor to inflation risk. Where each investor falls on the allocation spectrum is dictated by their individual situation; age, time-horizon, financial picture and risk-profile all come into play. It is important to understand that investor allocation(s) will change over time; they are not black & white. As personal and financial circumstances change, so will each individual investor’s allocation. Later in this blog we will dive into some of the quantitative and qualitative factors that cause asset allocations to evolve over time.
Diversification is spreading monies between multiple investments within an asset class. In the simplest terms, this means owning numerous stocks, bonds, properties, etc. On a more granular level, this is achieved through owning assets in numerous sectors, market capitalizations, geographies, economies and more.
Within an aggressive portfolio that may be 90% stocks, it is prudent to own more than 1 or 2 stocks. A diversified investor will have 20, 200, or even 2000 stocks in their portfolio (this can be accomplished through a single Mutual Fund or ETF). Diversification enables investors to minimize company specific risk, also known as unsystematic risk. If one company is 30% of your portfolio and it goes bankrupt and the stock becomes worthless, you have lost 30% of your portfolio value. But, if you have 100 companies in your portfolio (assume they are all weighted equally at 1%), and one company goes bankrupt, you have only lost 1% of your portfolio value. In this capacity, diversification reduces concentration risk and the effects of company specific risk.
Sector diversification means owning stocks (or any asset class) across a variety of business types, ranging from technology, communication, and financial companies to healthcare, consumer staples and utility companies. Each sector has unique attributes that enable them to perform better (or worse) through different stages of economic cycles. Growth companies, defined by high revenue growth, have historically done well during periods of economic boom. Value companies, such as consumer staples that people rely on for basic living needs, have historically done very well during periods of economic contraction. Macro economic changes are often hard to predict and can pivot quickly because of a singular event e.g. inflation, war, disasters, banking crisis, etc. Buying different sized companies, defined by their market capitalization, further diversifies a portfolio. The S&P 500 is only 500 of the largest companies in the United States. There are thousands of Small Cap and Mid Cap companies, some of which will grow over time and potentially become S&P 500 companies one day.
As Americans we often think very “world centric,” but the United States only makes up a portion of the global economy. Investors that ignore countries and economies outside of the United States are missing out on opportunities, and by default, adding risk to their portfolio through lack of diversification. Europe has some of the largest healthcare companies in the world. South America and Asia have emerging economies, as the United States and other developed countries have all gone through in the past. The United States has been on a great economic run over the last two decades, especially the last decade. However, an important part of diversification and sound investing is not letting past events distort future investment decisions. It is still important to be investing globally in today’s global economy.
Rebalancing involves buying and selling investments within a portfolio to return the allocation to its original weighting. Investing principles 101 state: Buy low and sell high. Rebalancing helps implement this principle. One common rebalancing method that is available to almost every investor with a 401(k) is to set periodic time intervals e.g. quarterly, semi-annual or annually. At each set interval, the 401(k) provider will make trades to automatically sell investments that are overweight and buy investments that are underweight to restore the asset allocation to its original allocation. This method is effective at taking the human error out of rebalancing by eliminating negative investor decisions like marketing timing and recency bias. Another type of rebalancing is to set drift thresholds on investment positions; this can be implemented in several methods. One method is to not let any single investment increase beyond a certain percentage of the overall portfolio. For example, setting a max concentration at 10%. If ABC stock increases from 8% to 12% of the portfolio, the investor trims 2-4% from ABC and reinvests the proceeds to underweight holdings DEF and XYZ. In addition, the main benefit of rebalancing is to keep an investor’s asset allocation centered around their original allocation; this keeps the risk/return parameters of the portfolio in-tact and the investor on track for meeting their financial goals.
What Data to consider when determining an Asset allocation?
ADR investing principles are important for both constructing and maintaining an investment portfolio on an ongoing basis. However, asset allocation also relies heavily on each individual investor’s needs, circumstances and behaviors to guide the appropriate allocation and asset selection. Quantitative data like income, assets, debt, and age/time-horizon provide an explicit data driven side to an investors financial profile, whereas qualitative data such as risk tolerance, career stability, behavioral biases and emotions, family needs, and financial goals provide a personal and behavioral side to the financial profile. Regardless, both types of data assist in selecting the appropriate asset allocation.
- The single most important factor when determining asset allocation is investor time-horizon. Investor time horizon can be viewed in two ways 1) the amount of time until the first withdrawal is made and 2) how long of a period withdrawals will be made over.
- Let’s look at the first time-horizon criteria and use a common goal for investors: the amount of time until beginning retirement distributions at age 65. An investor who is 30 years old and has 35 years until retirement should be heavily invested in growth assets such as stocks and real estate. These assets have the ability to outpace inflation, which is the biggest risk for long-term investors. The aforementioned investor will likely live through multiple economic cycles and experience numerous recessions causing declining portfolio values. Declining portfolio values, caused by depressed asset values, is an opportune time for young investors to stay focused on their goals and adhere to ADR principles; continue to rebalance when necessary to maintain their appropriate allocation and buy more shares of companies while assets values are depressed. On the flip side, a pre-retiree who is age 63 and will begin making portfolio withdrawals in 2 years has to consider additional risks and should have a different asset allocation. A pre-retiree has to consider they will begin making distributions from their portfolio, which brings the need for assets with stability of principal and income generating characteristics into the fold. A pre-retiree, and retiree, will have cash & equivalents in their portfolio so there is stability and liquidity for withdrawals to meet living expenses. This group of investors will also have an allocation to fixed income for its principal preservation and income producing characteristics.
- In the second time-horizon criteria, distribution periods can vary widely depending on the goal. Savings for a house down payments that is a one-time lump sum distribution versus distributing retirement assets over a 30 year period require vastly different asset allocations. A house downpayment should be highly liquid and stable so the investor knows exactly how much they will have available when they pull the trigger to make the purchase. While retirees do need cash and fixed income for stability and to make distributions from their portfolios, they also need to be cognizant of inflation. Over a 30 year period, inflation can eat away at a retirement portfolio’s purchasing power if there are no growth assets. A pre-retiree and retiree will typically have an allocation to stocks and real estate to maintain growth in their portfolio and purchasing power. The price of a gallon of gas, a dozen eggs and a pair of jeans are all higher now for retirees than they were 30 years ago.
- Additionally, other financial data comes into play for asset allocation. It can be difficult to make generic assumptions because every investor’s financial goals and feelings on risk are different. A higher earner can typically take more risk and have a more aggressive asset allocation because less of their income is going towards meeting living expenses and debt obligations. An investor with a high net worth is able to (but doesn’t always need to) take more risk because they have a higher risk capacity than someone with a zero or negative net worth. Risk capacity is the ability to take risk and absorb losses without it negatively affecting life and objectives. Think of a young investor with high interest student loan debt and also saving for a home down payment. From a risk standpoint, they cannot afford to be aggressive in their asset allocation for these goals because there is a high liquidity need. The funds need to be available to meet debt payments at rigid intervals or to make the down payment on demand.
- Qualitative data is much more nuanced with its effects on asset allocation. Whereas the quantitative side utilizes historical and projected data and statistics to create risk/return assumptions that shape asset allocation, the qualitative side is often fluid. Goals and objectives evolve as we move through life and experience career and familial changes. Our experiences shape our beliefs and values; how we feel about risk and loss shifts.
- Investor experiences and how that shapes risk tolerance has the largest qualitative effect on asset allocation. I think the most stark example of this happened recently. Young investors who hadn’t experienced the Dot Com Bubble or The Great Recession did not truly understand risk and piled into meme stocks, highly speculative tech stocks, and/or crypto during the last bull market, especially right after Covid. Many of these assets are down 90% or more from their highs. It will be interesting to see how absorbing such steep losses for many young investors will shape their asset allocations moving forward. Will they continue to indulge in large amounts of speculation? Will they gear their stock allocation to higher quality “blue chip” stocks? Or will they keep their allocation away from stocks all together? Many older investors that pulled out during The Great Recession did not get back into the stock market for years or all together.
- Behavioral characteristics, in my opinion, are the most intriguing aspect of investing and asset allocation. Biases and emotions like overconfidence, loss aversion, mental accounting, herd mentality, and confirmation bias all shape decisions investors make, and usually not for the better. Many times these biases and emotions cause people to make poor decisions with their asset allocation. For example, buying a meme stock because everyone else was doing it during 2021. Many of these people bought at the top and lost most or all of their money. For many investors, meme stocks were far too aggressive for their risk-tolerance and in-turn should not have been in their investment portfolio; if you are losing sleep over your investment decisions, the odds are you are over investing in risk-assets. On the flip side, many investors fear losses more than they appreciate potential gains; this is called loss aversion. Most investors who fear losses will be underweight stocks and real estate their entire life and will have a more difficult time building their net worth to outpace inflation. With behavioral factors, I believe investors can and should find a nice balance between acknowledging their unique personality and confronting their fears, to build an asset allocation strategy they can live with and stay committed to, both in periods of turmoil and exuberance.
ASSET CLASSES VS ASSET ALLOCATION VS ASSET LOCATION?
Asset allocation is half art and half science. In today’s world, we as investors have every tool necessary at our disposal to analyze all of the data in the world and create the ideal risk/return driven asset allocation to achieve our goals. However, if we cannot stay committed to solid investing principles such as ADR, and minimize human error, even the best asset allocation will not get us to our destination effectively.
Last month we discussed asset classes, this month we looked at asset allocation, and next month we will discuss asset location.