One of the most important strategies an investor can practice is diversification. Many investors don’t do this because they don’t think it’s important or they don’t know where to start. Other investors think their portfolio is diversified when it’s really not.
This is where the concept of asset allocation comes in, and that’s the topic of this article. We’ll define what asset allocation is and why it’s important, and we’ll talk about how to determine an asset allocation model. We’ll also describe how often you should change your asset allocation mix, provide an overview of the different types of asset allocation strategies, and we’ll tell you an easy way to apply asset allocation to your portfolio.
What is asset allocation?
Asset allocation is one of the most basic concepts of investing. Simply put, asset allocation means dividing (or allocating) your money among different asset classes (i.e. stocks, bonds, cash, real estate, etc.) and keeping it there. Asset allocation is a long-term investment strategy that many experts cite as the key to determining investment success.
The theory or the "why" behind asset allocation is simple. When some assets are up, others are down. The risk of investing is that you might not have your money in the right place at the right time. Asset allocation mitigates some of that risk by having some of your money in every place at all times. This strategy takes into account the way markets generally work and the fact that these asset classes all behave differently.
Even when multiple assets are moving in the same direction, they typically don’t move at the same pace or by the same percentage. When you spread your investment dollars among various asset classes, you are helping to ensure (although there are no guarantees) that at least one of the asset classes you own is going up, or at least staying the same. This keeps your portfolio less exposed to risk.
The opposite of asset allocation is market timing. This means not just buying low and selling high (that’s what all investors want to do, right?), but trying to know exactly when an asset class is going to move up or down. The idea is to jump from asset class to asset class at the right moments in order to maximize gains. This sounds appealing, but because no one can predict the future, market timing will often produce disappointing results.
How to determine an asset allocation model
As we mentioned above, one of the keys to asset allocation is finding a mix of asset classes and keeping it there. One of the mantras of investing is that, over time stocks will beat bonds, and bonds will beat cash. That is as true today as it ever was. But as we mentioned earlier, different assets typically behave in different ways, and sometimes they move in relation to one another. The investment cycle is different for different asset classes. Here are some examples:
- Small-cap stocks are more volatile than large-cap stocks.
- Stocks, in general, behave differently from Treasury bills.
- Short-term bonds behave differently from long-term bonds.
- Real estate often behaves differently from both stocks and bonds
- Gold stocks and other currency markets behave differently from other stocks.
The idea behind finding the right asset allocation model is to have different asset classes working to help you accomplish different goals. To find the mix that’s right for you, think about three questions:
- What mix of investments best suits your need for the goal that you have?
- What is your current age and lifestyle?
- Within each investment class, what is your risk tolerance?
For example, if you are saving for a new car or a house, you'll probably choose to put your money into very conservative investments like money market funds, short-term certificate of deposits (CDs) and, depending on your time frame, short-term bonds. This is because, regardless of age or lifestyle, you have a short- to medium-term goal and when it’s time to buy, you want assurance that the money you’ve saved will not have lost value.
But what about saving for retirement? That's going to take into consideration age and lifestyle. Someone who is young or who has the health and desire to stay in their career for quite a while may be more comfortable having the vast majority of their retirement account in stocks because they have time on their side. If there is a downtown in the stock market, they can simply leave their hands off those investments until prices come back up. However, an individual who is closer to retirement may choose to keep more money in bonds.
How often should you change your asset allocation mix?
Once you establish your asset allocation mix, you will have to make adjustments from time to time to make sure the mix stays in the proportions you desire. This is called rebalancing your portfolio and it affects what kind of strategy you will move forward with. The biggest question is, do you want a fixed mix or a flexible mix of investments?
With a fixed mix, you rebalance your portfolio (periodically) to maintain your fixed asset allocation model. The process of periodic rebalancing forces you to take profits out of your rising assets (selling high) and use those profits to buy assets that are cheap (buying low). This also helps you avoid assuming unnecessary risk because the percentages are kept at a predetermined level.
With a flexible mix, you keep changing the asset balances based on whichever asset class you see as being strongest. This is a form of market timing, although it does try to maintain a basic mix. The premise here does not necessarily mean that an investor does not want to practice asset allocation, but rather that they desire a more hands-on approach to their investments.
What are some asset allocation strategies?
Here are some basic strategies for asset allocation based on different ages and goals. Keep in mind, these are just guidelines, but they’ll give you an idea of how asset allocation works. To help provide a framework, it might be helpful to think of these strategies as being defensive strategies (i.e. guarding against risk) or offensive strategies (trying to maximize reward).
- Strategic Asset Allocation – This is the most passive of the strategies. Investors who use this method to establish targets for each asset class they invest in and rebalance their portfolio when the allocations deviate significantly from this base mix. This rebalancing can be done at any time, but generally, investors who practice this strategy are buy-and-hold investors and may only rebalance once or twice per year. Just because a base mix is established does not mean it won’t change, but that change would be done less frequently and only in conjunction with major life changes (i.e. retirement, the birth of a child) that impact investment objective and risk tolerance. While at times these investors may pass up on spectacular gains, they are protecting their portfolio from predictable risk.
- Constant-Weighting Asset Allocation – This is a form of strategic asset allocation where the rebalancing is done automatically. Many mutual funds allow you to do this when you set them up. So, imagine you have your portfolio set for 70 percent U.S. stocks, 20 percent international stocks, and 10 percent bonds. If international stocks surge and now comprise 25 percent of your portfolio, whereas bonds are now only 5 percent, the fund would automatically rebalance by selling some international stocks and buying more of the bonds to bring your portfolio back to balance. Many investors prefer this because it protects them against moving too slowly against major market shifts. Like strategic asset allocation, investors may not realize the gains that other investors will, but they are putting up a shield against risk.
- Insured Asset Allocation – On the other end of the risk spectrum is insured asset allocation. In this model, the asset allocation is based on a dollar amount rather than an investment mix. An investor will set a floor value for their portfolio and they will not allow the value of their portfolio to go beneath that floor. If it is above the floor, they invest in other securities that will allow their portfolio to grow. However, if the portfolio should fall beneath the floor, they will move back into less volatile assets (such as Treasuries or T-bills) to bring the portfolio back to its balanced state. This approach may work well for those living on a fixed income as it will help to ensure a minimum standard of living.
- Tactical Asset Allocation – This model adds an element of market timing to asset allocation. With this approach, an investor will intentionally deviate from their basic mix to take advantage of unusual or exceptional investment opportunities. This approach requires the discipline to bring your portfolio back to your desired long-term mix once you've achieved the short-term objective you desire or to cut losses if the opportunity does not pan out.
- Dynamic Asset Allocation – This is a more aggressive form of tactical asset allocation whereby you are constantly adjusting your asset mix. For example, when stocks are surging you buy more stocks at the expense of other asset classes. The goal of dynamic asset allocation is the same as strategic asset allocation, but the means to accomplish it are very different.
Can be an Offensive or Defensive Strategy
- Integrated Asset Allocation – This is the most complicated of the strategies and for that reason may be best left to experienced investors and those who are familiar with trading strategies. This strategy creates an asset mix that is based on your personal economic expectations, changes in capital markets, and risk tolerance. Essentially it tries to optimize your net worth and allocate your assets to accomplish that. A portfolio that is based on integrated asset allocation may have characteristics of dynamic asset allocation or constant-weight asset allocation, but not both at the same time.
How to apply asset allocation to your portfolio
One of the easiest ways to accomplish asset allocation is through mutual funds (stocks and bonds) and money market funds (cash). These take the guesswork out of your investing because, in the case of mutual funds, they are labeled as to their purpose. You can see what kind of stocks or bonds the fund is investing in, be they U.S. or international, and make selections based on your timeline and risk tolerance.
Another benefit of using mutual funds is that, in many cases, you can rebalance sometimes as frequently as every quarter without paying fees. This makes it practical for the buy-and-hold investor.
A similar approach to buying mutual funds is to look for index funds that are tied to different sectors of the economy (energy, technology, emerging markets) or perhaps a group of stocks in a particular exchange (e.g. the Nasdaq 100). Rather than choosing individual stocks, these funds offer diversification within each asset class by pooling your money into a basket of comparable securities. To achieve effective asset allocation, you would need to buy both stock ETFs and bond ETFs.
The bottom line on asset allocation
Asset allocation is one of the most important disciplines to help ensure an investor can achieve his or her goals. The three key variables in determining what asset allocation strategy is right for you are: your investment goal (i.e. retirement, saving for college, protecting wealth), your time horizon (young adults without kids have the time to ride out the ups and downs of the markets much more than an adult approaching retirement age), and finally, risk tolerance. After all, investing can be enjoyable, but it’s not for the faint of heart.
One of the most important elements of asset allocation is that it truly allows every investor to establish the portfolio that is right for them. Many an investor has gotten burned by trying to “keep up with the Joneses.” An asset allocation strategy gives an investor a level of stability that allows them to stay focused on the goals that are important to them. When you add the element of periodic rebalancing, investors can have a certainty that comes from knowing their portfolio is reasonably sheltered from market movements.