Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
The recent market volatility has exposed imprudent allocations in accounts that have resulted in significant losses to many investors. When asked about why account values have dropped, brokers often respond by blaming it on the market instead of recognizing that inappropriate allocations are actually to blame.
Research consistently has found the best way to maximize returns across every level of risk is to combine asset classes rather than individual securities (Markowitz, 1952; Sharpe, 1964; Brinson, Hood & Beebower, 1986; Brinson, Singer & Beebower, 1991; Ibbotson & Kaplan, 2000). Therefore the first is to identify a broad set of diversified asset classes to serve as the building blocks for a portfolio. Factors to consider are an asset class’s long-term historical behavior in different economic scenarios, risk-return relationship conceptualized in asset pricing theories, and expected behavior going forward based on long-term secular trends and the macroeconomic environment. Other useful tools include evaluating asset classes on their potential for capital growth and income generation, volatility, correlation with the other asset classes (diversification), inflation protection, cost to implement via ETF and tax efficiency.
Asset classes fall under three broad categories: stocks, bonds and inflation assets. Stocks, despite their higher volatility, give investors exposure to economic growth and offer the opportunity for long-term capital gains. Stocks provide effective long-run inflation protection and are relatively tax efficient due to the favorable tax treatment on long-term capital gains and stock dividends (relative to the way ordinary income is taxed). Bonds and bond-like securities are the most important income-producing asset classes for income-seeking investors. Although bonds have lower return expectations, they provide a cushion for stock-heavy portfolios during economic turbulence due to their low volatility and low correlation with stocks. Most bonds are tax inefficient because bond interest income is taxed at ordinary income tax rates, except tax-exempt municipal bonds. Assets that protect investors from inflation in both moderate and high inflation environments include Treasury Inflation-Protected Securities (TIPS), Real Estate and Natural Resources. Their prices tend to be highly correlated with inflation.
Time horizon is another consideration in determining asset allocation. Time horizon refers to the expected number of months, years, or decades 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 teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
Risk tolerance is the investor’s 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.
Many investors use asset allocation as a way to diversify their investments among asset categories. By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.