Quick Guide to Asset Allocation
Table of Contents
Quick Guide to Asset Allocation
One of the investment questions facing all investors is what the right asset allocation is, or asset mix, for them based on their needs, risk tolerance, and goals. There are exams you can take, there are questionnaires available, and then there is also asking your colleague about his/her allocation. Now I suggest a different option, which is understanding the differences between asset classes and then transposing that over your goals. Let’s take a deeper look, shall we?
Stocks
Your equity/stock allocation refers to your risk on or growth asset. Stocks at their core are basically owning shares of a massive publicly traded organization. Over time these assets are expected to grow at a faster rate than bonds, and inflation. The important thing to note is that these will be your more volatile asset class. Although over time they are expected to return roughly 8-10% annualized they’ll be subject to -30% years and +30% years. In three out of four years, historically, this asset class is up.
Bonds
Your fixed income/bond allocation generally refers to your much lower risk or income asset. Bonds at their core are owning a public company, or municipality, debt. Think equity owner is you own your house, and the bondholder is the bank that holds the mortgage on a fixed term. Bonds are MUCH less volatile than stocks only having roughly 5 negative years since 1976 (when the index began). Furthermore, stocks and bonds are rarely down in the same year (only happened once), and with the exception of 2022 even when bonds are down it is generally under 3% negative. Where stocks can be up or down 30% bonds generally are going to fall under 10% on both the plus and negative side.
The way up & the way down
Now that we have a general understanding of the two types of basic investments we get into in the markets, let’s talk about the two different stages of one’s life to consider one’s asset allocation.
The way up
In the first half of our investing life, we should look through the investment lens of investing on the way up. This is more commonly known as the accumulation stage. The key here, for asset allocation, is to have the right mix of stocks and bonds that give you the appropriate risk-adjusted rate of return you are comfortable with. Generally speaking, the more stock exposure you have the better returns over time, yet the more volatility getting there. Said differently, the less concerned you are about your investment account having bigger swings in values and the more concerned you are about maximizing your growth potential, means you should have a higher stock exposure. Naturally, the converse holds true as well. There is no “right” formula for everyone rather this must be vetted by how you will react to market swings, your goals, and the risk you need to take. For instance, I am virtually 100% stocks as I want maximum return and have tons of risk tolerance.
The way down
You know what Sir Isaac Newton said, “What goes up, must come down.” That is why the second stage I like to refer to as the way down, or in better-known nomenclature the spend time stage. This is probably the most critical and nuanced part of one’s investing life. This is where you have to really get your allocation right as it is more dynamic. It is more dynamic because not only do you have to have the right blend for continued growth, but you also have to have the right blend to continually withdraw your funds without running out of investments. There is clearly a financial planning process and discipline that is needed, more on that in a future blog. However, for today let’s think about it through a different lens. You want to make sure you have enough equities that your assets continually appreciate, and yet enough bonds that you can pull funds consistently and regardless of what is happening in the stock market. The key here is to have enough “dry powder” in bonds to get you through market dips so that you do not have to sell stocks when they are down. Remember, buy low sell high. For what it is worth we at Diversified have a great system for the withdrawal stage of your life.
Crash course concluded
And when you are up you’re up, and when you’re down you’re down, and when you’re nearly halfway up you’re neither up nor down. Isn’t the brain a funny thing, I couldn’t get that little grade school rhyme out of my head this whole time. In any event, there is your quick crash course in investment allocation. I find the key is to set it and forget it to some degree as once you are comfortable with your risk tolerance it is time to let investments run their course.
Stay wealthy, healthy, and happy.