Sunday, August 5, 2012

What's Your Allocation?

Studies have shown that a very large driver of variation in returns for portfolios is derived from different asset allocations.  Focusing on having the right asset allocation can help improve your returns on investment over time and is a more reliable driver of returns than either stock picking or market timing.  There is often much debate over any "ideal" asset allocation as it differs among individuals.  I'll just go over some of the general themes and rules of thumb on how to think about asset allocation.

The biggest factor in asset allocation most financial advisers will tell you is your age.  The younger you are (or more accurately, the farther you are from retirement), the more assets you should have in higher yielding stocks and equities.  As you move closer to your desired retirement age, you will want to shift some of those equity assets into safer fixed income securities like bonds.  You want to try to avoid having too much cash and fixed income assets in the long-term because those returns will get eaten up by inflation.  However, you do want to make sure you have enough cash to fund your emergency fund for short-term liquidity.

The second largest factor is your risk tolerance.  If you can stomach more volatility in your returns, you will want to take advantage of the higher long-term returns of equities as well and put a higher weight on it.  If seeing your investments drop 10% makes you lose sleep, you may want to have a higher allocation to fixed income assets.  You never want to sacrifice your comfort for some extra percentage points of return on your portfolio since you may be more likely to panic and do something harmful to your investments during a downturn.  Make sure you are comfortable with the level of risk you are taking on at all times.

Most other factors you want to take a look at when deciding your asset allocation play a smaller role.  If you have a more positive economic outlook, you will want a higher weight in equities.  If you want a higher income stream in the years to come before retirement, you may want to have a higher weight in fixed income or dividend paying stocks.  If you are in a high tax bracket, you may want to have a higher weight in municipals.

As you drill down to subgroups of asset classes, you can get a better idea of which subgroups are better for your specific outlook and goals.  You want to always maintain an appropriate level of diversification unless you are truly convinced that you know what securities will outperform during your holding period.  You can separate stocks into large-cap,  mid-cap, and small-cap with large-cap stocks being relatively safer than small-cap stocks.  You can also separate between domestic and international stocks.  For the U.S., international stocks are probably a bit more volatile and offer a higher rate of growth than domestic names.  Fixed income can be split among normal bonds, TIPS (inflation protected), and municipals (tax-advantaged).

The most important thing is probably to make a goal and take the steps to reach that goal.  If you only need 5% growth in your portfolio to reach whatever goal you have, you probably shouldn't take on a lot of additional risk to get a 10% return.  After each year, you should also look at how your allocation has changed and rebalance your portfolio to fit your desired asset allocation.  For example, let's say your current allocation is 70% stocks, 20% bonds, and 10% cash.  After a really great year in the stock market, your equities slice of the pie has risen to 80% of your portfolio.  If you want to keep your old asset allocation, you will want to sell some of those equities and buy some more bonds and leave some in cash.  There can be tax-advantaged ways to pick the stocks that you sell and other minute details, but you should make sure that you asset allocation doesn't deviate too far from your initial allocation before rebalancing.

Is there some magic set of numbers that tells you exactly how much you should have in each asset?  No, but there are fairly good rules of thumb on when you should have a higher weight in equities and when you should stick with safer fixed income assets.  Make a goal and a plan to reach it.  Don't take on additional risk for returns that you don't need.  Follow these guidelines, and your investments should serve you well.

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