What is Asset Allocation?
Asset allocation is the proportion of invested assets held in various investment types. Asset allocation is typically referred to as the ratio of stocks to bonds one owns in their portfolio.
“Don’t put all of your eggs in one basket.”
This is fitting advice for a multitude of circumstances.
I’m sure my parents recited this phrase to me a few times, but it always makes me think about Mel Gibson.
That may seem odd, but if you recall the mid-90s hit movie, Maverick, starring Mr. Gibson, James Garner, and Jodie Foster then you’ll understand why I make the mental association.
And, if you don’t know, well, feel free to google it. It has almost nothing to do with asset allocation.
However, eggs and baskets are exactly the metaphor to help us understand why we should spread our invested assets out across a spectrum of assets.
Put simply, asset allocation refers to the proportion of various investment types and classes held in one’s portfolio to match your tolerance for risk, your appetite for yield, and how much time you have before you need to liquidate the investment.
Going back to our eggs and baskets metaphor, asset allocation is how we describe our strategy for distributing eggs into baskets.
For example, if you have a very low tolerance for risk, you will probably put more of your eggs into a low-risk asset basket like bonds, CDs, money markets, or even cash.
On the other hand, if you have plenty of time to invest and want to produce the highest possible returns, you’re more likely to invest a larger portion of your money in a basket with stocks or real estate.
Why Does Asset Allocation Matter?
Asset allocation matters because our tolerance to risk changes over time.
In 2008, my portfolio took a huge hit like everyone else’s.
I can distinctly remember March 5, 2009, when the Dow descended to 6,594. This was over 50% below the Dow’s all-time high in October of 2008 which was over 14,000.
My co-workers were in a panic.
It’s understandable. The market hadn’t seen a day that bleak since the Great Depression, though you could argue we saw something equally as radical on October 19, 1987.
Me? I was excited.
My excitement was driven by two things:
- I was ignorant of just how bad things were. Frankly, we were closer to an even larger disaster than I realized at the time.
- I thought everything was on sale. I was grabbing every available dollar I could find and buying mutual funds in domestic stocks.
It’s not that I enjoyed watching my portfolio shrink to half of what it once was. But I did see the stock valuations as a once-in-a-lifetime opportunity to buy equities at bargain basement prices.
Once everyone stopped freaking out I was certain anything I bought would rebound quickly, putting me years ahead of where I expected to be entering my 30s.
The optimism I felt at the time easily outweighed any pessimism.
But in 2009 I also had less than $50,000 invested. A 50% haircut was still only $25,000 for me and represented only 2 or 3 years of saving.
I didn’t have a whole lot to lose.
Many of my co-workers, on the other hand, were 50 and older and were watching decades of saving slip away in a flash.
They understood how long it took to build up their precious nest eggs and probably thought they were watching their retirement slip decades further into the future.
I think I would have been nauseous too if my risk tolerance was similar to theirs.
The point is my ability to absorb risk for the sake of return was very high while that of my more senior co-workers was very low.
Their asset allocation should have had a greater tilt toward low-risk investments like bonds than I would have had at the time.
In this way, at least some portion of their investments would have been sheltered from stock market risk.
Alas, there was nowhere to hide in 2008. It was a monetary massacre and we all felt the pain, though bonds may have experienced slightly less of it.
What Are My Asset Allocation Options?
To begin, let’s categorize investments into three basic categories that will serve as our asset allocation baskets.
We’ll call the basket that includes equities the “stocks” basket. This may include mutual funds, ETFs, pure stocks, or other investments that are ultimately rooted in the ownership of an asset or company.
Our “bonds” basket contains investments that own debt, like…bonds. It could also include treasuries (again, debt), or fixed-income assets like CDs and money market accounts.
Finally, “Cash” is another basket that we won’t talk about much, but it is certainly important.
We won’t talk about cash much in this post because cash isn’t really an investment. You sure as heck need it, especially when you don’t have it, but it is always subjected to the deteriorating effects of inflation.
The best news about cash is that it is almost risk-free. It won’t grow, but if you leave it in your account it will be there when you come back for it.
Asset Allocation Jargon
From this point on, we’ll refer to asset allocation as a percentage of stocks vs bonds, respectively.
So, if we reference the most popular 60/40 asset allocation, we mean the subject portfolio contains 60% stocks and 40% bonds.
It’s safe to assume there’s usually some cash too, but pretty much everyone ignores cash when addressing asset allocation.
If you owned 85% stocks, you’d have an 85/15 asset allocation.
Not exactly rocket science, but it’s important to know that stocks are the asset that is referenced first.
What Should My Asset Allocation Be?
Your exact asset allocation is up to you and your financial adviser if you work with one, but we’ll give some food for thought and a few popular guidelines for setting your asset allocation.
Generally speaking, the older you get, the more people typically shift from stocks to bonds so their portfolio grows more conservative over time.
The reason for this is as you lose time to invest due to your age, you carry a greater risk that your “stock” investments won’t have time to recover their value before you need to sell them and live off the proceeds in retirement.
You don’t want to have to sell stocks in a year like 2008… 1987… 2000… 2018…or 2023.
By having a larger portion of your asset allocation in bonds, you give yourself a basket of money that isn’t subject to the same market risks as stocks (at least not normally).
So, when bad years come, which they will, you can use income from your bond portfolio to avoid selling stocks at the worst possible time, while also giving your stocks time to recover.
Of course, this means your asset allocation will begin to tilt toward stocks and more risk, so you may have to adjust your investment strategy accordingly.
You may also want to consider moving to a more conservative asset allocation as you accumulate more wealth, regardless of your age.
Once you’ve got enough money to live on comfortably, there’s no reason to leave it in risky assets that could experience a sudden decrease in value.
An Age-Based Rule of Thumb
The most common rule of thumb for asset allocation is to subtract your age from 120 to calculate the percentage of your investments that should be in stocks.
For example, using this formula, a 40-year-old would have an 80/20 portfolio because 120-40=80.
This an okay guide but I don’t really love it.
By the math, you wouldn’t reach a 60/40 portfolio until you turn 60. And why would it be appropriate then?
The formula doesn’t account for personal goals, current financial status, terms of investment, and a host of other characteristics.
Furthermore, depending on who you ask I’ve seen suggestions to subtract your age by 110 or 100 to arrive at an appropriate asset allocation.
How are you supposed to know which suggestion is correct? It’s so subjective.
Feel free to take this into account, but you need to consider your whole financial picture before making a decision.
Again, this may be an opportunity to consider hiring a financial planner to help you out.
The Rebalancing Effect
There’s also a potential growth benefit that comes from maintaining a strategic asset allocation.
You probably know the oversimplified goal to “buy low, sell high” when investing in stocks. You probably also know this is challenging to do because no one knows when prices will be high or low.
By rebalancing your portfolio every so often, you force yourself to sell stocks or bonds when they are at high prices and buy the other investment when its prices are low.
Here’s an example to explain.
Let’s assume you have a 70/30 portfolio strategy but stocks have been on a run lately so that side of your asset allocation has swelled to 75%.
There are a few ways to rectify this and get your asset allocation back to where you want it.
- You can buy bonds instead of stocks;
- You can just sell the stocks;
- You can sell the stocks and rebuy bonds
Any of these will get you back to your 70/30 asset allocation, but the last two force you to sell your stocks when they are priced high.
If you use option three, you could potentially be buying bonds while they’re underpriced or at least low compared to stocks.
This “pre-programs” your decision to buy and sell so that it is driven by good planning instead of market timing.
If you work with a financial advisor they can usually do this for you. Some of them adjust asset allocation daily to keep your portfolio on track.
If you manage your investments yourself you could do this once or twice a year and be fine.
You could also set a rebalancing limit so that if you get overweight by say 5% or more in stocks or bonds, you’ll do a quick rebalance.
I wouldn’t go very far beyond 5% though. A 5% increase in stocks would mean a 5% decrease in bonds, which is a 10% overall change.
An Asset Allocation Shortcut
If the complexity of asset allocation gives you a headache, you can shortcut this by using target-date mutual funds instead.
A target date fund is a mutual fund that owns a percentage of both stocks and bonds.
Over time, the fund shifts its asset allocation into bonds so the holdings become more conservative.
They are named using a date in the future to define the expected retirement date of the mutual fund’s shareholders.
So, if you plan to retire in 2040, the idea is you would select a target date 2040 fund to enjoy “set it and forget it” asset allocation.
If you don’t want to have to worry about adjusting your asset allocation over time or think you might forget, target date funds can be a great answer and they typically enjoy low fees to boot.
Personally, I do not use them for reasons I will discuss below, but I have owned them in the past and they are a great option to consider.
The Martin Family Asset Allocation
I try to be very clear on this site that we don’t give financial advice through our posts. There’s just no way to account for everyone’s specific situation or tolerance for risk.
What I can do is tell you about us.
For several years following 2008, we purchased shares in a 2045 target date retirement fund to take advantage of the simplicity they offer.
After a few years of what I felt were less than-optimal returns, I dug into the assets contained in the fund.
As it turns out, it was far too conservative for my blood.
We were tired of returns that were a percentage point or two behind the S&P 500 each year, so we sold our target date funds and went 100% into stocks.
Well, we own mutual funds and ETFs that own stocks.
This is a definite tilt into higher risk but after more than a decade in this asset allocation, we have no regrets.
The reason is even though the stock market is riskier than bonds, with a long investment horizon (say 7+ years), the risk of stocks is reduced significantly.
Enough, in our case, to go 100%.
Also, interest rates have been so low for years now. Bonds are not where you want to be when interest rates rise and when they were at all-time lows as long as they were, there was only one direction they could go.
As we approach our 50s, we will probably shift about 2-3 years of living expenses into bonds which will hopefully be less than 10% of our portfolio, but our risk tolerance is pretty high.
We would also warm up to bonds if interest rates continue to rise and yields begin to reach above 5%.
Finally, I am vested in a defined benefit pension plan which will provide additional income in retirement. While not a bond, it works a lot like one and I consider the risk profile similar.
No need to overdo it with even more bonds in my portfolio.
Again, this may not be the allocation for you. I’m just trying to be transparent in case you’re curious.
Asset Location
When addressing asset allocation, the topic is often confused with asset location.
Where asset allocation addresses the percentage of our assets that are allocated to various investment categories, asset location refers to the tax status of the account in which we hold those assets.
So, you may have a 60/40 stocks to bonds portfolio, but that portfolio could be completely invested inside of a Traditional IRA or 401(k), or perhaps it’s in a Roth IRA?
Or it could be divided in some proportion of both and even a taxable brokerage account.
Both asset allocation and asset location are important to understand, but asset allocation comes first.
We’ll be covering asset location in depth in our next post.
