With every client, my goal is to create a tailored investment strategy that manages what we can control. After considering variables like investment fees, taxes, and comfort levels with volatility and risk, we often settle on something called an asset allocation. The term gets thrown around a lot, so I want to delve into the virtues of asset allocation and what purpose it serves in helping manage a stronger portfolio.
What is asset allocation?
First off, what is an asset allocation? Asset allocation can be an overall strategy for a client’s portfolio or a singular action specific to a financial situation. Let’s imagine a pie that we cut up into various pieces. Each piece has a specific type of asset associated with it. Examples of assets include stocks (sometimes referred to as equities), bonds, cash, real estate, and gold. Within each financial plan, we decide how large those pieces should be based on the objectives we’re trying to achieve.
By their nature, certain assets like stocks are designed to grow. Remember, stocks are little pieces of ownership in companies. Owning stocks over long periods of time generates more growth in our investments than, say, bonds or gold, which tend to be more stable and slower to grow. However, the characteristics of an asset make them a better fit depending on the situation.
Stocks, for example, possess the superior long-term chance of growing our portfolio the fastest. But there’s a trade-off: volatility, the degree to which stocks may move up and down in a given year. More volatility = more anxiety. The high level of volatility generally makes people uneasy and more likely to make costly moves (selling when they get nervous, for instance). On the other hand, bonds as an asset class are significantly less volatile, but they will also grow a lot more slowly too. You get the idea.
So why not just make 100% of the pie the asset class we think will grow the most? I’m glad you asked!
Your Portfolio Needs Diversification
Most people can’t tolerate the volatility that comes along with putting all the eggs in one basket. And it’s also helpful to have some diversification in the types of assets because not all markets move together all the time. This helps to smooth out our returns somewhat. That’s called diversification.
Different Goals Mean Different Asset Allocations
Need money to buy a house? Or saving for lifestyle change in 30 years? Those two goals will have very different investment strategies. Generally speaking, the closer in time we are to a goal, the safer we want to be with our investments; the farther away the goal is, the more risk we can take with an asset.
An Asset Allocation Helps Us Rebalance
One of the most beneficial parts of an asset allocation is that before we invest a dime, we set policies regarding our investment strategy. Then when we encounter a rising or falling market, we know exactly what to do instead of panicking and doing something we regret. The process of re-adjusting the portfolio to the policy or investment analysis is called rebalancing. The process of rebalancing forces us to sell in up markets and buy in down markets.
Here’s an example: Let’s say we have a $100,000 where we have a 50/50 investment split between stocks and bonds. If our stocks fall 10% and our bonds return 3%, at the end of the year we have $96,500: $45,000 in stocks and $51,500 in bonds. Our asset allocation will tell us to purchase more stocks to re-establish that 50/50 ratio. With an asset allocation, our portfolio has consistent exposure to our desired assets while still allowing us to profit from them; plus it keeps us grounded when things get hairy in the stock market.
Read More: Creating an Investment Plan: Tune Out the Noise!
We Can Control Risk
The thing people hate most about investing is the possibility of losing money. With an asset allocation, we can control how much risk we take with our money. Don’t want our portfolio to ever fall 20%? No problem! We can design an allocation to prevent that. The flipside is that our portfolio might not grow as much, so we have to save more.
This last point is particularly important. We often read of horror stories in the news about someone losing their life savings because of a volatile stock or the stock market. Oftentimes, that person’s portfolio has never been rebalanced or controlled for risk, which is why unfortunate situations happen in the first place. The take-away is that these events are preventable by using strategies like asset allocations.
At the end of the day, an asset allocation is critical for investment success (and peace of mind) over time. Blindly investing our money doesn’t do us any good. Sometimes managing this process can feel like a lot. That’s where having a partner like a financial planner can be worth its weight in gold (maybe literally). In the long run, using an asset allocation as a roadmap for our portfolios will be one of the most consequential things we can do for our financial health.
Sticking to a plan is easier said than done. If you need help strategizing about your long term investment plan, contact me for a consultation. I can help with your investment management needs.
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Jim is a financial advisor and owner of Thinking Big Financial, Inc. Thinking Big Financial is a fee-only registered investment advisor offering financial planning and investment management services. Specializing in working with the LGBTQ Community.
Please read my legal disclaimer here.