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Asset Allocation Basics

I never dedicated a post to talking about asset allocation. It’s an incredibly powerful tool in order for the investor to achieve their goals. Without it, all you have is an investment product – with an AA, you actually have a strategy to use that investment product. It’s what helped me retire early by avoiding excess investment risk.

Below is a diagram showing how one’s asset allocation can be structured. On the far left are the descriptive terms used for each specific asset allocation. And though the terminology is arbitrary, the rate of return is quite a bit affected by your asset allocation.

Not only is it important to choose your asset allocation wisely but it’s important to have one in the first place. More than half of my colleagues don’t have an actual asset allocation. They have “some bonds” and “some stocks” but “thinking of getting out of bonds because of their poor returns”.

Your asset allocation can do a lot for you, including:

  • increase your rate of return
  • decrease your risk
  • smooth out the volatility of the market
  • prevent you from buying high and selling low
  • allow for diversification
  • allows you to time the market properly

What Is An Asset Allocation

Asset allocation is a term you might come across when talking to your financial adviser. It’s also something that you will need to determine when trying to decide how much of each individual investment to hold.

A simple example of asset allocation is how much you have dedicated to bonds and how much to stocks. Of course, you may have no bonds and hold cash instead or you might hold only stocks and nothing else. In the latter example, your asset allocation is still important. In your all-stock portfolio would decide upon the exact breakdown of the kind of stocks you would hold.

My Asset Allocation

To give you an example, I have 2 different asset allocations, one for my tax-deferred portfolio and one for my taxable accounts. Traditionally, it’s advised that you treat all your investments the same and choose one single AA for all of them. My financial adviser and I chose to separate them out for sake of simplicity.

My asset allocation in my taxable account is supposed to be 70% equities (stocks) and 30% bonds (fixed income). I say ‘supposed’ because my AA has shifted due to recent market changes – it’s my job to set it back to 70/30 which I’ll talk about below. In my tax-deferred (retirement) accounts, I have a goal asset allocation of 90% equities and 10% bonds. 

My asset allocation breaks down even further. In my taxable account, for example, my goal is to have 50% international equities and 50% US equities.

In my tax deferred retirement accounts, my asset allocation for equities leans 25% towards small cap, 5% is REITs, and the other 70% is a blend of equities.

It’s now 2023 as I update this article and though the asset allocation holds much less bonds it’s still heavily skewed towards securities. I also own 3 real estate properties which I would consider less investments since they are vacation homes but they have resale value.

Is It A One-Time Set-It & Forget-It?

Even though when you first start investing a sum of money you get to decide how much to invest in what, your investments all move at different rates.

My bonds are declining currently while my equities are at an all-time high. This has thrown my AA off by so much that it’s hard for me to adjust my AA. Let’s talk a little about AA adjusting.

Adjusting Your Asset Allocation

It’s important to regularly adjust your AA, we’ll discuss why towards the end of this post. There are several simple ways of adjusting it. You should choose whatever makes the most sense to you, keep things simple, simple is sustainable and sustainability is profitable.

1. Through Purchasing

If your asset allocation is off when you go to invest extra money, you simply buy more of the asset class which is down and avoid buying any of the appreciated asset.

Your investments should be in constant flux – that’s what makes investing profitable. It’s how you respond to the fluctuations that determines whether you will pocket profits or lock in losses.

Let’s say, I have $100,000 invested and want to be 80% in equities and 20% in bonds. Well, currently in 2017, bonds are as sexy as a dude in a bikini. Not only would my bonds be down by a lot but equities will be up, distorting the shit out of my desired asset allocation of 80/20.

If my 80%/20% now has become 95%/5% then I need to focus on buying only more of my bond funds until I can get the ratio closer to 80/20. So, any new money I earn through my job will be used to purchase more bonds until I reach the 80/20 ratio again.

2. Through Selling

If you’re retired or no longer contributing to your investments because you’ve saved enough, you won’t be able to use the “purchasing” method above to keep the proper ratios of your asset allocation. Instead, you would need to sell the assets which have done well and buy more of those that haven’t budged or which have declined.

From the same example above, that 95%/5% would get adjusted back to 80/20 by me selling enough of my equities holdings to buy the proper quantity of bonds. Voila!

For this latter method, you also have to determine how often you will adjust your AA.

Are you going to do it as soon as there is a tiny fluctuation, even a few dollars? Unlikely, that would require daily adjusting.

Are you going to adjust when there is a major fluctuation? Perhaps a shift of 5%? Yea, that’s a pretty good method – if there is a 5-10% shift, that’s when you adjust.

Are you going to adjust based on a timeline? Not bad either, maybe 1-2x a year you can check on your investments and see if adjustment is needed.

Why Have An Asset Allocation?

Many book chapters are written about why it’s important to have an asset allocation. By having an AA you are simply a more savvy investor. You decide on your asset allocation based on your risk tolerance and your desired rate of return.

1. Earn A Higher Return

It’s important to understand that by having an asset allocation you increase your rate of return. But remember, you have to stick with it. I have several friends who are on the same investing path as myself, doing everything as well as possible but when it comes to the AA, for some reason, they won’t make the proper adjustments. I have some ideas as to why they are hesitant to take action which I’ll address towards the end of this long-ass post.

The reason your asset allocation allows you to have a higher return is multifactorial. I pointed out in a recent post that the average investor underperforms the market by several standard deviations.

If the investor is exposed to too much risk, doesn’t buy the right thing at the right time, sells low and buys high, then it doesn’t matter if they are invested in the most lucrative of investments – they will destroy their chances for any meaningful gains.

If a high-earning healthcare professional held on to their investments through the 2008 downturn and kept investing throughout it, they would be insanely ahead right now. Not only did their initial investment recover, they also got a chance to buy the same funds at a 40% discount for a year straight.

There is a timing strategy¬†… sort of… incorporated in an asset allocation. Because you are buying investments which are doing poorly and not buying more of the ones which have appreciated, you are in fact constantly buying the same investments at lower and lower prices.

2. Decrease Risk

The asset allocation you have come up with has taken into account your risk tolerance, which means you are less likely to panic and make a wrong financial move. In doing so you have hopefully understood the common ups and downs with the particular investment you are choosing.

As an example, you have added in enough fixed-income assets such as bonds or cash to offset the higher risk & volatility that’s inherent in stocks. And though you may earn a higher return for taking a higher risk, it may not be in your best interest if you don’t have enough time left in the market to allow for reversion.

Every time you come into more money to invest, you will buy the asset class which has dropped in value based on your AA. You know the assets you hold to be a good investment, otherwise why the shit would you have bought them? You are capitalizing on the funds being at a lower price instead of constantly buying them at higher and higher levels just to watch them drop eventually.

From 2003-7, many real estate investors saw their real estate portfolio double in value. It would have been a mistake to buy more real estate even though RE was hot. Instead, if their RE allotment was 50% of their AA, the investor would either sell some of the appreciated RE to get back down to 50% or would have invested any extra revenue into whatever the other 50% was. This would have decreased their risk of losing a lot during the subsequent RE market crash of 2008.

And… taking this example further, that investor would have loaded up on RE when the market crashed, because now their RE portfolio was probably 25% and their securities investment was 75%, instead of their AA goal of 50/50. Even if both RE and securities dropped in value, the investor would put more money into the investment which lost more value. This would allow them to come out of the crash with a gang of RE investments, purchased with a huge discount.

3. Decrease Volatility

Stocks are volatile and they are becoming more volatile as the economic landscape changes – so I’ve read. Sure, an all equities portfolio will spend the majority of its time going up, +5% one year, +15% another, +10%, etc.

But there will also be times when the market is just blah! Your funds twerk in place but don’t make any meaningful gains and don’t even drop much in value. And then every few years your all-equities portfolio will drop -20%. And a few times in your lifetime you will even see that portfolio drop by -50%.

The above defines volatility. It’s not pleasant even though in the long-run it will make you wealthier. In order to avoid these turbulent returns, investors add in some cash, some bonds or REITs or other asset classes. The goal is to smooth the ride and thereby decrease the volatility (pdf).

Even an all-equities portfolio can be designed to have less risk and volatility. That’s why you add a little more value stocks, maybe decrease your small cap funds, and add a little more international funds to your portfolio.

Barriers To Adjusting Your Asset Allocation

As I mentioned, even the best designed index fund investing strategy can go to shit if you aren’t willing to adjust your asset allocation when it needs adjusting.

There are several barriers as to why we may not be paying adequate attention to our asset allocation. It’s obviously not intentional, so let’s identify them and cure them.

1. Not Understanding The Power Of AA

I hope this post helped explain why having an asset allocation is important. How it can increase your return, decrease your risk, make you sexier, and decrease the volatility of your portfolio. Because if you understand how powerful an asset allocation is then you will just be better off by putting in the effort it takes to maintain your asset allocation.

2. Taxes

What I love about retirement accounts is that I never have to worry about taxes whether my investment goes up, down or sideways. I can buy and sell as much as I want and I won’t have to worry about paying taxes on any gains – well, at least not until I decide to take money out of my retirement account (deferred taxation).

In a taxable account it’s another issue. If I have to sell some funds to buy other funds then I may encounter a taxable situation. Fortunately, you and your financial adviser will have chosen investments which are taxed favorably in taxable accounts.

Still, despite the tax implications, it’s often advisable to readjust your asset allocation based on the parameters you have set for yourself.

3. Fear

Some investors are afraid meddling with their investments in any fashion. They don’t even want to buy them, much less sell them. If it’s a matter of a quirky website with your brokerage house, you can just call them and they can handle everything on the phone for you.

Another way fear surfaces is that we get influenced by the media. In 2017, as of this writing, when bonds are getting a bad rap, the last thing the investor wants to do is buy more bonds.

In fact, many investors want to do nothing because even stocks seem overvalued to them. Their rationale is that it makes no sense for them to buy a fund which will just drop during the next market crash. In fact, even though your hot investments will soon correct, in the long-run they will keep going up.

4. Greed

As investors we want the highest returns possible, which means that we certainly don’t want to be selling out of our appreciated funds to buy the poorer performing ones. Unfortunately, by giving into this mini-greed, we are decreasing our overall chance at locking in great returns.

And it’s not just about “great” returns. If we don’t treat our AA the way it’s meant to be treated then we may expose ourselves to excess risk. What does excess risk do? It creates fear, and fear will make you sell low and buy high. You’ll sell low because you’re terrified of how much lower your investment could go and you’ll buy high because you’re worried that you’ll never get a piece of that delicious vegan blueberry pie.

5. Complexity

I decided to throw complexity in here as well. Unfortunately, some investors go out of their way to create an insanely complicated portfolio, not realizing that the more investments you hold the more rebalancing you have to do.

Simplifying your finances has one of the highest returns, I highly recommend it. Sure, you can get super fancy, have 18 different funds across 7 accounts – but you aren’t gonna earn a higher return because of it, at least nothing you can’t earn in a few hours of clinical work.

As a word of warning, some financial advisers try to create really complicated portfolios in order to justify their fees without being able to explain why.

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