When I got my first job in finance, I was so excited! I was fascinated with the stock market, and now I had access to some of the best research and data. My computer screen was set to display real-time stock quotes for at least fifty companies. But every day that I looked at my computer screen, there was one thing that stood out. When the stock market was up, all the stock prices on my computer screen were up. And when the stock market was down, all the stock prices on my screen were down.
In short, the prices of stocks generally move in the same direction. Seeing this every day, I began to appreciate an important investment concept. The markets’ up days showed me that the actual stocks you pick are not the most important consideration in your success. What is most important is whether you’re invested in the stock market at all.
Meanwhile, the down days illustrated the importance of having the right asset allocation in your investment portfolio. But what exactly is asset allocation?
Asset allocation is dividing your money among the different assets classes based on your investment objectives, time horizon, and risk tolerance. There are three major assets classes: stocks, bonds, and cash. They differ in the their risk characteristics and potential returns.
Stocks: Of the three main asset categories, stocks have historically provided the greatest returns. They are also the riskiest and most volatile. The risk characteristics associated with stocks make them unsuitable for short-term objectives. But over the long term, investors who can hold on during bear markets and periods of volatility are rewarded.
Bonds: Bonds have historically been less volatile than stocks. However, the historical returns have been more modest. Investors in bonds are typically looking for more stable returns in return for less risk (and less possible reward). Important note: some bonds classified as “high yield” or “junk bonds” based on their ratings have the potential to provide returns equivalent to stocks, but also carry a high degree of risk.
Cash: Cash and cash equivalents have the least amount of risk but provide the lowest return. This category includes checking and savings accounts, certificates of deposit, money-market accounts, money-market funds, and Treasury Bills. You can generally expect your principle to be safe when investing in these instruments, but the expected return may not keep pace with inflation.
There are other assets classes such as real estate and commodities, but stocks, bonds, and cash are the most common in retirement accounts and college savings plans.
How do you determine what asset allocations are right for you? The two most important considerations are your time horizon and risk tolerance.
If your money is going toward a down payment on a new home, a new car, an emergency fund, or any short-term objective, protecting your principle investment would be the priority. For these examples, cash or a cash equivalent is suitable.
If your investable funds are for retirement and your retirement date is ten or twenty plus years away the greatest percentage of your investment portfolio should be in stocks. Your asset allocation should only have a small percentage in bonds and cash. Stocks historically provide the greatest return and with a long-term time horizon since you can ride out the volatility and bear markets associated with stocks.
What if you are approaching retirement age or are saving for your kid’s college and graduation day is only a few years away? Then, your assets should have a smaller percentage allocated to stocks and a greater percentage in bonds and cash.
Today there are a variety of different asset allocation calculators available for you to determine the right mix of stocks, bonds and cash. They will ask you a series of questions to determine your time horizon and gauge your risk tolerance. And just like that, you’ll get an asset allocation recommendation! The financial institution you’re with will most likely have one.
Don’t forget to rebalance your portfolio!
Periodically, you need to review your investments and make sure your asset allocation is still in line with your objectives. Over time, you’ll likely see that one asset class has outperformed the others and is out of balance with the original allocation. To maintain the balance, you’ll need to sell the assets from the asset class that outperformed the others and use the proceeds to buy the underperforming asset class.
This may seem counterintuitive. Why would you want to sell the assets that are doing so well? The answer is easy: it forces you to buy low and sell high. The strategy here is not to try and time the market, but to manage the risk and uncertainty that goes with investing.
When should you rebalance?
Rebalancing can be done yearly, quarterly, or monthly. The exact time period is not the most important factor. It’s making sure you’re disciplined and consistently rebalance on the schedule you’ve decided.
You can also rebalance based on when the percentage of your asset allocation model deviates by a certain percentage. For example, say you want to maintain a balance of 60% stocks and 30% bonds and 10% cash. Your trigger to rebalance can be when an asset class deviates by more than 10% of the original allocation. In this scenario, you would rebalance if the stock portion of your portfolio grows to more than 70%.
Another method for rebalancing is to add funds to the underperforming asset class to maintain the planned allocation mix.
Diversification is just as important!
Having the right asset allocation won’t reduce your risk if you only have one stock and one bond. You need to have diversification within each asset class. You need to hold a variety of companies and sectors within each asset class. This way, you limit your exposure to any negative event in one company or business sector.
One of the best ways to diversify is to invest using mutual funds or exchange-traded funds (ETFs). Each fund will invest in a variety of companies based on the fund’s objectives. To simplify asset allocation even further, there are target-date funds that not only invest in a variety of companies, but also maintain an asset-allocation mix based on the date when an investor needs the funds. You simply pick the fund with the target date that coincides with the date you plan to retire, pay tuition, or whatever your goal is.