I came across a very interesting chart this week showing returns by asset class over the past 15 years. It triggered some thoughts on how and why you should diversify your investments across various asset classes (a practice called “Asset Allocation”). As a result, today’s article will focus on why asset allocation matters, and how you should think about the topic in relation to your overall personal finance strategy.
Asset Allocation – Defined
In my earlier Building Block series, I dedicated an article to various asset classes available to investors, including stocks, bonds, equity mutual funds, international funds, real estate, etc. For a refresher on the various asset classes, please click HERE to review that article. Once you understand the asset classes, it becomes interesting to see how they perform over time. More important is how they perform relative to one another, as the primary goals of asset allocation is to own a diversified portfolio of assets to provide a natural hedge, reduce volatility, and optimize returns. In the event an asset class declines, the theory is that another will rise, offsetting your losses and resulting in a more stable long term investment return. (If you’re interested in learning more, a good place to start is with Harry Markowitz’s Modern Portfolio Theory,)
The chart below is the one that triggered today’s article. Each column represents a year, each row an asset class ranked according to that year’s performance. The top row is the highest performing asset class for each year (the bottom row, the worse). There’s no clearer way to explain the importance of asset allocation than to simply look across the years and see how various asset classes rise and fall. In 2014, for example, Real Estate had the highest return at 25%. Only one year earlier, Real Estate was in the lower third, with a negative return of -1.4%. Commodities, with 4 years in the top three rows in the 2000’s, have now had 5 years in the bottom three rows. Just look at the colors (representing different asset classes) along the top row, they change almost every year:
Chart from Henion & Walsh
In contrast, have a look at white box that runs across the middle row, titled “Asset Class Blend”. It represents a well diversified portfolio, and maintains a consistent position and relatively steady returns. While it never achieves “top row” status, it also avoids “bottom row” status every year.
How Do I Determine My Asset Allocation?
Many folks may think they’re diversified simply because they own numerous funds. As Jon Dulin points out in The Myth of Diversification, the risk in this thinking is that there may be “overlap” in the holdings between your various mutual fund accounts, and you may not be as diversified as you believe. It’s very difficult to determine your true asset allocation simply by looking at the fund types you own – you need to understand the composition of the holdings within your funds.
One of the best tools I’ve found to keep track of your personal asset allocation is Personal Capital, a free online financial software tool that I highly recommend. I use it, and strongly encourage you to have a look if you’re not already using it. After loading all of your investments into the site (a relatively painless process), it creates numerous charts for your current situation, and updates them automatically every day. Below is an example of one of the asset allocation charts they produce automatically (NOTE: not the author’s data, this was pulled from a demonstration screen shot I found online):
What’s My Optimal Asset Allocation?
Now that you know how your assets are currently allocated, the obvious question becomes “What is the best asset allocation for me?”. Some folks use the simple rule of thumb that “100 Minus Your Age determines what percentage of stocks you should own”. For example, a 20 year old should have 80% stocks, a 60 year old should have 40% stocks. While this is a good starting point, it’s too simplistic to be anything more than a starting point.
To move from the “rule of thumb” to a more personalized strategy, the key is to first determine two key issues:
- What level of risk you’re able to tolerate (What’s your “Risk Profile”)?
- What level of return do you require to meet your lifestyle objectives?
If you’re less comfortable facing the prospect of losses in your portfolio, or you don’t necessary need a higher return to achieve your goals, you would target a “lower risk” allocation (less stock, more fixed income). Don’t take more risk than is required, take only the risk that’s required to achieve the appropriate level of financial return. Vanguard offers an 11 question risk assessment tool on their website which provides a suggested asset allocation target – it’s a much better place to start than the “rule of thumb”, and will only take 2 minutes of your time.
In the words of Roger Whitney from a Retirement Answer Man podcast I heard this week, the goal should be to accept the “minimum effective dose of volatility” required to achieve your goals. If you’ve done well, have built a large portfolio, and have a steady pension, you likely require a lower level of return to fund your retirement. In this situation, your asset allocation should lean toward a lower risk profile.
To get a sense of how some of the “experts” view asset allocation, a good article to read is Three Investment Gurus Share Their Model Porfolios. In it, three different “Gurus” (big hitters, these, including Vanguard’s Jack Bogel and Yale’s David Swensen) provide very specific guidelines and some good commentary on things you should consideration. An example of the content is below – take the time to read the article:
Another consideration is how much time is required before you’ll need to access the funds. The longer the time horizon, the more risk you can tolerate. Even if you’re already retired, an effective “bucket strategy” should provide a sufficient “cash cushion” to tolerate more risk if your goals require a higher return to keep up with inflation.
To determine my targeted asset allocation, I’m using Vanguard’s suggested allocation as a starting point, and believe it’s a very good baseline for you to consider with your own account. Rather than follow their advice blindly, however, I’m factoring in my own personal view and making conscious, intentional exceptions. For example, I’m hesitant to invest as much in “bonds” as they suggest given the risk of interest rate increase. Therefore, I’ve substituted some Peer-To-Peer lending and other similar alternatives toward the “lower risk, lower return” allocation target normally invested in bonds.
How Do I Transition To My Optimal Asset Allocation?
Now that you have a targeted asset allocation, and know your current allocation percentages, how do you make the transition to close the gap?
I’m in a situation where I have more cash reserves than the suggested allocation (party intentionally, as I’d prefer to hold cash rather than my targeted bond allocation, given the risk of an interest rate increase. Secondly, with the strong equity markets through the early part of this year, I’ve taken the opportunity to “pocket some of the gain”, selling equities and raising cash).
Emotionally, I have a hard time moving significant portions of my portfolio in big “chunks”, so I’ve elected to automate regularly scheduled transfers between my accounts. Several times a month, money is automatically redirected from my cash reserves toward the assets where I’m below my targeted allocation. Whenever there’s a large move in the markets, I accelerate the re-allocation via “one time” manual transfers (for example, I moved some additional money from cash to equities during the stock market correction last month). I’ll run this process for the next ~12 months, at which point I plan on being within my targeted range.
Once you’ve gotten close to your targeted allocation, an annual rebalancing process helps keep you there. Rebalancing involves looking at your year-end allocation and making adjustments to get you back in range. For example, if your target is 60% equity / 40% bonds and the stock markets have been strong, your year ending allocation may be 65% / 35%. To adjust, you’ll sell equities, buy bonds. This forces a “sell the winner, buy the loser” approach, which is often counter-intuitive if you’re used to a more “emotional” management of your portfolio.
Finally, if all of this is simply too overwhelming for you to handle, you may want to consider to have it professionally managed. Radical Personal Finance recently ran an excellent podcast on “How To Chose A Financial Advisor”, which is the best information I’ve ever seen on the topic. A lower cost option may be to use one of the “Robo-Advisors”, who will manage this automatically for you, but may not provide the personal touch you’d find with an individual advisor. A final recommendation, and one I plan to use when I reach the age where I no longer want to manage this myself, is to use Vanguard’s Personal Advisor Services, which is a bit of a hybrid between “pure personal advisor” and “robo-advisor”, but charges only a 0.3% fee.
Regardless of your approach, recognize the importance of being intentional in deciding what percentage of your portfolio is being allocated across the various asset classes. Take time to understand where you currently have your money, then make the necessary adjustments to improve on your current approach. Over time, you’ll be rewarded for the effort through higher average returns, lower volatility and higher odds of achieving your goals.