What is “asset allocation” and why is it important?
Asset allocation is a term for describing how much of each
investment class you should have in your investment portfolio. John Heinzl of
The Globe & Mail says that asset allocation is related to the concept of
diversification – “the idea that you should spread your risk across different
investments so you won't be overly exposed to a downturn in one particular area”.
In other words, don’t put all your eggs into one basket!
Unfortunately, many investors forget all about asset allocation
– until it's too late! That was painfully obvious during the market collapse of
2008-2009, which blindsided investors who had devoted too much of their
portfolios to stocks. For those near retirement, this would have been disastrous.
Investopedia.com, an excellent resource for investors and
students, says:
“There
is no simple formula that can find the right asset allocation for every
individual. However, the consensus among most financial professionals is that
asset allocation is one of the most important decisions that investors make … In
other words, your selection of individual securities is secondary to the way
you allocate your investment in stocks, bonds, and cash and equivalents, which
will be the principal determinants of your investment results.”
The process of determining which mix of assets to hold in
your portfolio is highly subjective and there is no obvious right answer. What
will suit you best any given point in your life will depend largely on two main
factors:
1. Time Horizon. Your time horizon is the expected period of time
(months, years, decades) that you will be investing to achieve a particular
financial goal. An investor with a longer time horizon may feel more
comfortable taking on a riskier, or more volatile, investment because he or she
can wait out slow economic cycles and the inevitable ups and downs of our
markets. By contrast, an investor saving up for a down payment on a house would
likely take on less risk because he or she has a shorter time horizon.
2. Risk Tolerance. Risk tolerance is your ability and willingness
to lose some or all of your original investment in exchange for greater
potential returns. An aggressive investor, or one with a high-risk tolerance,
is more likely to risk losing money in order to get better results. A
conservative investor, or one with a low-risk tolerance, tends to favor
investments that will preserve his or her original investment. It is important
to remember that all investments involve some degree of risk and that your reward
for taking on investment with higher risk is the potential for a greater investment return. Any decent investment
advisor will typically ask you to fill out a questionnaire to assess how well
they would react in a severe market decline and then design your portfolio
accordingly.
Investment Classes
A vast array of investment products exists - including
stocks and stock mutual funds, corporate and municipal bonds, bond mutual
funds, lifecycle funds, exchange-traded funds (ETFs), money market funds, and
treasury securities. For many financial goals, investing in a mix of stocks,
bonds, and cash can be a good strategy. Let's take a closer look at the
characteristics of the three major asset categories, by order of most risk to
least risk.
1. Stocks and Equities. This asset category has historically had
the greatest risk and highest returns among the three major asset categories.
The volatility of stocks makes them a very risky investment in the short term,
but investors that have been willing to ride out the volatile returns of stocks
over long periods of time generally
have been rewarded with strong positive returns.
2. Bonds and Fixed Income. Bonds are used by companies,
municipalities, and various levels government to finance a variety of projects
and activities. Bonds are generally less volatile than stocks but offer more
modest returns. The two principal determinants of a bond's interest rate are credit
quality and duration. Also, keep in mind that certain categories of bonds offer
high returns similar to stocks. But these bonds, known as high-yield or junk
bonds, also carry higher risk.
3. Cash and Equivalents. This category includes such as savings
deposits, GICs, T-Bills, and money market funds. These are widely considered
the safest investments, but offer the lowest return of the three major asset
categories. The principal concern for investors investing in cash equivalents
is inflation risk (the risk that inflation will outpace and erode investment
returns over time).
It should be noted that in addition to the three main asset
classes, some investment professionals would add real estate, precious metals
and commodities to the asset class mix. This will be the topic of future
postings on this blog.
Asset Allocation Models
Here are some general “asset allocation models” that are
designed to help investors and advisors in categorizing their preferences. These
are largely goal based (i.e. buy a house in the next 6 months, retire by the
age of 60, etc.) and many financial firms typically will provide funds and
portfolios along these lines.
1. Capital Preservation. This is for investors who intend to use
the money sometime in the near future or who would lose sleep if their
portfolio went down even a few percentage points. This is not really an
“investment” as it usually sits in a savings account or some short-term
guaranteed investment such as government bonds or 30-day GICs. The goal is to
protect your capital, earn a very small amount of interest (desirably at or
above the rate of inflation), and liquidity for when you need cash in hand.
2. Income. The income portfolio is designed for those who need the
income from their investment. It usually is retirees but could be anyone who
needs the income from their investment for any purpose. The majority of the
investments are in income generating vehicles such as government and corporate
bonds, Income Trusts and quite often large dividend paying companies. The
investor that utilizes the income model is typically a retiree and not
concerned with growth, but wants capital preservation and the safety of income.
3. Balanced/Income-Growth. Probably the most common model used is
the balanced model and pretty much anyone can fall into this category as it provides
somewhat more stability. A simple portfolio of this type would have 60% in
stocks and 40% in bonds. This model aims to provide a level of capital
protection as well as growth opportunities.
4. Growth. This is a more aggressive model and its main goal is to provide
capital appreciation with no or little income. A typical growth investor is a
young employed individual who is looking to increase their net worth and do not
care much about income or capital preservation. Types of investments held in
here are mostly growth stocks (ranging from 50-80% of the total portfolio) and maybe
some small portion in dividend stocks and high-yield bonds.
5. Aggressive/Speculative. This is the most risky model and not
many investors fall in this category. I think this model resembles casino
gambling as this type of investor is in for the quick buck. Types of
investments are small start-up companies, IPOs, or companies in some type of
distress where the outcome is very uncertain. There generally is no fundamental
or technical analysis and is based on “gut feelings”.
To help you decide what kind of investor you are and the
asset mix appropriate for your situation, here are the links to a few online calculators
to try out:
·
http://www.smartmoney.com/calculator/investing/managing-asset-allocation-1304479164310/
·
http://cgi.money.cnn.com/tools/assetallocwizard/assetallocwizard.html
·
http://www.bankrate.com/calculators/retirement/asset-allocation.aspx
·
http://www.money-zine.com/Calculators/Investment-Calculators/Asset-Allocation-Calculator/
For fun, try them all and try to see where they differ and
where they agree.
Other Strategies
I’ve come across a few interesting alternative strategies
with regards to asset allocation. The first one I will discuss is called “lifecycle
investing” which basically advocates that you “diversify across time”. The
argument is that traditional asset allocation does not give you much growth
when you are young and have a long time horizon with a relatively small
portfolio – so this type of investor should put ALL of their available funds
(including borrowing money to invest) into equities. The investor will gradually
move into 100% fixed income portfolio by retirement. While theoretically sound,
I am personally uncomfortable with young investors “putting all their eggs in
one basket” and leveraging their portfolio to magnify returns as it leaves the
investor vulnerable to not having enough cash on hand in case of emergencies.
Another interesting investment strategy that I recently came across was while
reading Nassim Nicholas Taleb’s 2007 book titled The Black Swan: The Impact of the Highly Improbable. Taleb argues
it's possible to ward off “black swans” using a "barbell" method that
consists of “taking both a defensive attitude and an excessively aggressive one
at the same time, by protecting assets from all sources of uncertainty while
allocating a small portion for high-risk strategies”. In other words, barbell
strategies typically involve balancing your investments between two extremes.
In this case Taleb recommends putting 80% of your assets into relatively stable
investments (i.e. government bonds and GICs), and the remaining 20% in risky
securities like stocks and commodities.
Some Final Thoughts
One of the most important things to remember is that overtime
your asset mix will shift. Your stocks may outperform your bonds and this will
shift your original asset allocation so every ones in a while you will have to
do what is called a rebalancing of your portfolio to bring it back to its
original goal allocation. I strongly recommend that at least once a year you
review your investments and your financial goals and decide which strategy is
the most appropriate for you.
No comments:
Post a Comment