Asset Allocation And Your Portfolio

Asset allocation is the process of dividing the money in your investment portfolio among stocks, bonds and cash. The goal is to align your asset allocation with your tolerance for risk and time horizon. Broadly speaking, the three main asset classes are:

• Stocks. Historically stocks have offered the highest rates of return. Stocks are generally considered riskier or aggressive assets.
• Bonds. Bonds have historically provided lower rates of return than stocks. Bonds are typically considered safer or conservative assets.
• Cash and cash-like assets. While you don’t typically think of cash as an investment, cash equivalents like high-interest savings accounts and guaranteed investment certificates (GICs) are all ways that investors can enjoy potential upside with very low levels of risk.

You’re probably already familiar with thinking about your investment portfolio in terms of stocks and bonds. But cash and cash-like assets are also an important piece of the asset allocation puzzle. These highly liquid assets offer the lowest rate of return of all asset classes, but they also offer very low risk, making them the most conservative (and stable) investment asset.

You can buy individual stocks or bonds to get your desired asset allocation. But new investors should stick to exchange traded funds (ETFs) and index funds. There are countless funds to choose from, each of which owns a very broad selection of stocks or bonds based on a particular investing strategy (like matching the performance of the S&P 500) or asset type (like short-term municipal bonds or long-term corporate bonds).

With asset allocation, you divide your investments among stocks, bonds and cash. The relative proportion of each depends on your time horizon—how long before you need the money—and risk tolerance—or how well you can tolerate the idea of losing money in the short term for the prospect of greater gains over the long term.

Asset Allocation & Time Horizon

Your time horizon is a fancy way of asking when you’ll need the money you’re investing. If it’s January and you’re investing for a vacation in June, you have a short time horizon. If it’s 2020 and you plan to retire in 2050, you have a long time horizon.

With short time horizons, a sudden market decline could put a serious dent in your investments and prevent you from recouping losses. That’s why for a short time horizon, experts recommend your asset allocation consist mostly of cash assets, like savings, GICs, or even certain high-quality bonds. You don’t earn very much, but risks are very low, and you won’t lose the money you need to go to Aruba.

With longer time horizons, you may have many years or decades before you need your money. This affords you the opportunity to take on substantially more risk. You may opt for a higher allocation of stocks or equity funds, which offer more potential for growth. If your initial investment grows substantially, you’ll need less of your own money to reach your investment goals.

With aggressive, higher-risk allocations, your account value may fall more in the short term. But because you have a far-off deadline, you can wait for the market to recover and grow, which historically it has after every downturn, even if it hasn’t done so immediately.

After each recession since 1920, it has taken the stock market an average of 3.1 years to reach pre-recession highs, accounting for inflation and dividends. Even taking into account bad years, the S&P 500 has seen average annual returns of about 10% over the last century. The trouble is you’re never sure when a recession or dip is going to arrive. As your investing timeline shrinks, you probably want to make your asset allocation more conservative (bonds or cash).

For goals that have less well-defined timelines or more flexibility—you might want to take a trip to Australia at some point in the next five years but don’t have a set date in mind—you can take on more risk if you’re willing to delay things until your money recovers or you’re okay with taking a loss.

Asset Allocation & Risk Tolerance

Risk tolerance is how much of your investment you’re willing to lose for the chance of achieving a greater rate of return. How much risk you can handle is a deeply personal decision.

If you’re the type of investor who’s not comfortable with big market swings, even if you understand that they’re a normal part of the financial cycle, you probably have lower risk tolerance. If you can take those market swings in stride and know that you’re investing for the long term, your risk tolerance is probably high.

Risk tolerance influences asset allocation by determining the proportion of aggressive and conservative investments you have. On a very simple level, this means what percentage of stocks versus bonds and cash you hold.

Both high and low risk tolerances will lose money at some point in the investment cycle—even if it’s only to inflation—but how big those swings are will vary based on the risk of the asset allocation you choose.

Even if you’re comfortable with a lot of risk, your investing timeline may influence you to hold a more conservative portfolio. If you’re only a few years from retirement, for example, you might switch to a bond- and fixed-income-heavy portfolio to help retain the money you’ve built up over your lifetime.

Choosing the right asset allocation maximizes your returns relative to your risk tolerance. This means it helps you get the highest payoff you can for the amount of money you’re willing to risk in the market. You accomplish this balance through the same kind of diversification mutual funds and ETFs provide—except on a much broader level.

Buying a mutual fund or an ETF may provide exposure to hundreds if not thousands of stocks or bonds, but they’re often the same type of asset. A stock ETF offers diversification in stocks but you’re still undiversified in terms of asset allocation. If one of the companies in an ETF goes bankrupt, your money is probably safe. But if the whole stock market crashes, so do your savings.

To diversify your asset allocation, split your money between a stock ETF and a bond ETF. This helps protect your money because historically, stocks and bonds have an inverse relationship: When one is up, the other is generally down. Striking a balance between the two can position your portfolio to retain value and grow no matter what markets are doing.

To see how asset allocation works in the real world, here are retirement scenarios for three different investors.

Investor A: 22 years old, 40 years to retirement, high risk tolerance

This investor is interested in growing their retirement savings over the next 40 years. They know the market will have ups and downs but are more interested in holding investments that will offer the potential for a higher rate of return. They want a diversified portfolio that allows them maximum exposure to the stock market and its historically high rates of return.

Their retirement investment portfolio might look like this:

• 80% stocks
• 40% large-cap stocks
• 30% mid-cap stocks
• 30% small-cap stocks
• 15% bonds
• 5% cash

Investor B: 40 years old, 15 years to retirement, moderate risk tolerance

This investor still has more than a decade to go until retirement but less time to recoup any major market losses. They’re willing to take on some risk to keep their money growing but don’t have the luxury of multiple decades to replace any money they might lose between now and retirement. They want a diversified portfolio that will offer modest upside but still protect them from major market downturns.

Their retirement portfolio might include:

• 60% stocks
• 60% large-cap stocks
• 20% mid-cap stocks
• 20% small-cap stocks
• 30% bonds
• 10% cash

Investor C: 60 years old, beginning retirement now, low risk tolerance

This investor is celebrating the end of their working years and looking forward to using their retirement savings to explore new horizons. Losing money really isn’t an option since the money they’ve already saved needs to last for the next 20 or more years. They want a diversified portfolio that helps preserve their capital while offering them selected opportunities for upside—but without taking on a lot of risk.

Their retirement portfolio might look like:

• 30% stocks
• 100% large-cap stocks
• 50% bonds
• 20% cash

As you can see, differing time horizons and appetite for risk dictate how these investors choose to allocate the assets in their portfolios. While these profiles are only samples, they should give you an idea of how asset allocations can change from one risk tolerance and time horizon to another.

Asset allocation isn’t a one-time event. Your desired asset allocation changes over time as you get closer to your goals. But even before then, you may notice portfolio drift, or the movement of your allocations away from where you set them. This could happen if stock values rise suddenly or if bond interest rates (and their associated prices) fall.

Most experts recommend you check in on your portfolio once or twice a year to see how it’s doing. Depending on your holdings’ performances, you may need to rebalance, or sell some securities and buy others to bring your asset allocation back into line.

Determining the right asset allocation you need shouldn’t be a difficult process, but it does require periodic maintenance. If you’d prefer to leave management of asset allocation to professionals, consider investing in target date funds or robo-advisors.

Target date funds and robo-advisors typically offer easy ways to invest in diversified portfolios of mutual funds and ETFs. They automatically rebalance your holdings to maintain your desired level of risk and rebalance them as you approach the date when you need access to your money.

Robo-advisors take the automation of your asset allocation even further. When you sign up for a robo-advisor, the platform asks you a series of questions about your time horizon and your risk tolerance. The platform then automatically tailors the asset allocation of your portfolio to your goals with no further input needed.

While convenient, neither approach is typically free. Fees and expenses associated with target date funds are generally higher than they would be if you invested in the funds they invest in yourself. The same is true of robo-advisors, which typically charge annual maintenance fees. But if you would prefer a hands-off approach, you may be willing to pay a small premium for ease of use.