Asset allocation is a vital piece of an investment portfolio. It drives an investor’s potential risk and return possibilities. Many advisors will tout their investment selection but miss the big picture when it comes to deploying assets.
There’s a big difference between asset allocation and investment selection.
Think of your investment options as a grocery store. The store is broken out into sections (e.g., produce, dry goods, frozen foods, meats and dairy), and within those categories you have a large selection of products (such as five different types of milk).
Your investment options are similar in that you have categories to select from (e.g., equities, bonds and real estate) and then many options within the categories to select (e.g., equity mutual funds and ETFs) from many different companies.
The hard part is knowing which ingredients you need to make dinner every night.
Many advisors spend time with their clients talking about investing in the right managers or investments and not enough time on the asset allocation. The issue with this approach is that the investment might not match the recipe that fits the client’s needs. Grocery stores are good at getting you to walk out with random items that were a good price but you did not really need. This is true for the investment world as well. An advisor might recommend the best private real estate manager in the world even though the client already has an appropriate amount of real estate outside their portfolio and thus does not need that type of exposure.
Starting with a financial plan and an appropriate asset allocation to achieve your goals is the best place to start so you don’t end up with all the random items in your cart.
The importance of diversification
One big ingredient to your investing “recipe” should be diversification. Investments are usually broken into five categories: cash, equities, fixed income, real estate and alternative assets (e.g., private equity, commodities and hedge funds). Why? Mainly because they each behave differently in varying market conditions. Combinations of those groupings help you build a diversified portfolio.
For example, when equity markets decline, fixed income usually holds up well or may increase. A combination of those two groups can help a portfolio decrease volatility and increase the likelihood of achieving long-term goals. The mix of these categories determines how much risk and consequently how much return you can expect from your portfolio.
As part of the financial planning process, your financial advisor will know how much risk you are willing and able to take in your portfolio. Some people want to up the spiciness of their recipe with some peppers, while others want to keep it mild. So it is with the amount of risk you want in your portfolio. Studies have shown that a large percentage of your portfolio risk and return are based on your asset allocation choices, so figuring how much risk you’re comfortable with is a very important step to choosing that allocation.
So, how do you ultimately decide what fits your recipe?
Historical data on the behavior of asset classes and the current market environment helps financial advisors project what long-term expected returns and risk are at a given time. Fixed income tells you what interest rate you can expect to earn by buying bonds. Equities can be modeled based on factors such as current prices, growth expectations and earnings. By analyzing each area, you can come up with long-term expected returns.
While it is very difficult to guess what returns will be in the short term, longer term fundamental factors tend to be a better predictor of results. Once you have an idea of these long-term assumptions, you can start to make the recipe to help ensure you are on track to achieve the best long-term returns with the appropriate amount of risk.
Choosing the asset allocation that is appropriate for you
Let’s go back to the greatest private real estate manager in the world. If you know the real estate assets in which the fund invests are not a good long-term investment, the manager may be able to outperform relative to the asset class but still underperform badly compared to other places you could have invested. This means you picked a relatively great investment but a poor option in terms of absolute performance for your portfolio.
Having a research-based, fundamental approach to building overall portfolios can give you a better chance to avoid the impulse buys and flashy sales, thereby keeping you disciplined and sticking to your shopping list where you can optimize risk and return to best meet your needs.
In the end, be wary of advisors who are only pitching you products and ingredients of an overall portfolio rather than an integrated solution. Asset allocation is a valuable piece of the overall financial puzzle. Wipfli Financial Advisors can help you craft the appropriate recipe for your long-term financial goals. Contact us to learn more.