Have you ever wondered what exactly asset allocation consists of? Do you hear everyone from your investment advisor to your banker tossing this term around? In this blog we’ll try and explain what it means and give you some suggestions on how you can think about allocating your assets.
In the simplest of terms, asset allocation is about investing in stocks and bonds in different asset classes that are not correlated. Asset allocation is one of the most important factors that can affect long-term financial success. When building your financial plan, it is important to spend a lot of time thinking about asset allocation, as this is the foundation of your portfolio. You want to choose a strategy that you can stick with for the long term, and not move in and out of the market during volatile times. Remember, you can’t achieve long term returns without going through the normal ups and downs of the market.
Quantitative Analysis of Investor Behavior1
Do you wish you had a calculator where you could input all your data, wait a few seconds, and watch the program recommend how you should allocate your assets? Unfortunately, there is no one formula for choosing the right asset allocation. Instead, here are a few factors you should consider when deciding how to allocate your assets:
Time horizon: If your investments have a long time horizon, you might be able to be more aggressive in your choices because you will have a lot more time to recover from the ups and downs of the market. Also, keep in mind that various accounts could have different time horizons.
Amount of cash in the bank: How much cash you have in the bank should tie in to your investment allocation decision. For example, if you have enough cash in the bank to cover your living expenses for the next 5 years, then you most likely won’t need to touch your portfolio for a number of years. This means you may be able to take more risk in your portfolio knowing you have ample cash in the bank. However, if you have little cash in the bank and you think you may need to draw from your portfolio, then you should choose a less risky portfolio.
Quantifying the downside of a portfolio: It helps to quantify how much a portfolio can actually go down in a bad market. Don’t just look at the return a portfolio might provide, focus on the downside risk, too. You can’t achieve the return you want over the long term unless you stick with the portfolio through the ups and the downs.
Allocation of other assets: It’s important to look at your financial life as a whole, not in piecemeal fashion. Make sure all portfolios (taxable accounts and retirement accounts) are thoughtfully aligned to match your risk tolerance.
These are just a few of the many factors to consider when deciding how to allocate your assets. Remember, there is no right answer as to which asset allocation you should be in, just make sure it is something that you can stick with for the long term.
And also remember, this decision is very personal and specific to YOU.
The media, colleagues, and friends do not know your risk tolerance and objectives, so make sure not to make a move based on the opinions of others. Instead, continue to evaluate your plan at least once a year to make sure it is still appropriate for you.
Getting your asset allocation choice correct from the start is your first victory in a successful financial strategy!