During periods of market volatility, such as recently experienced in the first quarter of 2018, having the proper asset allocation can help you sleep at night. If your portfolio is allocated correctly, it should yield reasonable long-term returns. The right asset allocation will depend on several factors which determine how much risk you can afford to take both financially and emotionally.
What is asset allocation? Simply, it is not putting all your eggs in one basket; however, the more formal answer is how an investor distributes money into various asset classes in order to diversify risk. Asset allocation is based on the concept that no two asset classes will perform the same over time and that consistently guessing which asset class will have the best performance is very difficult. Each asset class usually reacts differently to economic events; therefore, each has its own risk / reward characteristics that determine how much of the asset is appropriate for a portfolio. Conservative (risk adverse) investors will have less of a risky asset than an aggressive investor. While there are a number of major asset classes to consider, I will cover the three major classes, stocks, bonds (fixed income) and cash for illustration in this article. I will also include a brief discussion of some alternative asset classes later in this article.
The definition of risk as it pertains to investing is the chance that an investment’s actual returns are different than what is expected. In addition to both up and down changes in value, risk includes the possibility of a permanent loss to a portion or even the entire original investment. Lower risk generally equals a lower rate of return. Which follows the general axiom of investing: The more risk taken, the higher the expected rate of return and the higher the possibility of loss.
Stocks generally offer the greatest return among the three main asset classes, they also have the highest degree of risk and uncertainty. Bonds have historically returned less than stocks and correspondingly a lower degree of risk. Cash will normally offer the lowest return and usually has the least amount of risk. To show the differences in returns for the separate asset classes, I've included a chart of the average annual return over last 15 years for stocks, bonds and cash.
Determining what asset allocation is appropriate for an investor begins with determining how much risk an investor is willing to assume. There are two main factors to consider for determining risk tolerance. The first is how much risk an investor can afford to take financially, which is their ability to take risk. Financial risk, meaning, can that particular investor afford to lose those invested funds. If Investor A is worth $10 million and Investor B is worth $100,000 and each invested $100,000, Investor A would have more of a financial ability to risk that $100,000 than Investor B. Financial risk is analyzed by reviewing an investor’s time horizon, age, income requirements, and overall financial situation. The greater the time horizon, the more risk an investor should be able to sustain. Investors with short time horizons (5 years or less) generally should have more exposure to safer assets. For example, if an investor has a time horizon of 2 years, it is usually not appropriate to have 100% of their portfolio in stocks due to the potential to lose a portion or all of those funds is higher versus other safer investments. As the need for certainty of outcome increases, the level of risk that an investor can afford to take is reduced.
The chart below illustrates three basic asset allocation models.
The second factor to consider is how much risk an investor can handle psychologically, this is known as their willingness to take risk. Having an ability to stomach the ups and downs of the market will have an influence on the appropriate asset allocation strategy that fits the investor. For example: Two investors with the same ability to take risk may have different willingness to take risk. In a year when the stock market returns are down 20% for example, Investor A may be able to tolerate the loss, versus Investor B who cannot. Because Investor A can stomach these types of potential scenarios, they will most likely allocate most of their funds to stocks, where as Investor B will probably allocate most of their funds to bonds and cash. Investor A is willing to take on the additional risk that stocks offer in hope of the larger expected return. Whereas Investor B, would rather reduce the potential risk and accept lower expected returns.
Besides the big three asset classes, we often get questions concerning other asset classes. There are plenty of other asset classes that are outside of the widely held big three; such as private equity, options, gold and oil, to name a few. These other asset classes may have a place within your portfolio and are appropriate for many different types of situations and reasoning. If someone does choose to include them within a portfolio, our recommendation for how much to allocate is based on that particular investor’s overall financial situation.
Below is a table with the average annual return over the last 15 years for stocks, bonds and selected other asset classes.
Note: Data provided by First Trust Portfolios
Note: Results are the geometric mean for the last 15 years from each asset classes’ respective index
1. US Long Term Treasury Bonds returns are represented by the Bloomberg Barclays Long Treasury Index which consists of public obligations of the U.S.Treasury with 10 or more years to maturity.
2. US Long Term Corporate Bonds returns are represented by the Bloomberg Barclays Long Credit Index which consists of investment-grade bonds issued by corporations and non-corporate entities with 10 or more years to maturity.
3. Foreign Stocks are based on the EAFE Index.
Evaluating an investor’s risk tolerance can be difficult. It is normally done with a series of questions to assess an investor’s reaction to certain events. Questions usually focus on the factors previously discussed: The financial ability to take risk and the willingness to take risk. These factors help to determine the proper asset allocation. Several online brokers, 401k plans, and other “do-it-yourself” sites have profiling questionnaires as part of their services. Once the questions are answered, then a proposed asset allocation is provided. While useful, these questionnaires can be limited as to the scope of factors considered and may not cover all of an individual’s personal situation. It is usually helpful to speak to a qualified financial planner or financial advisor to help determine what asset allocation strategy is most appropriate.
As always, please let us know if you have any questions concerning asset allocation. Thank you for reading.
Investopedia on Asset Allocation
SEC on Asset Allocation
Vanguard on Asset Allocation