In its simplest terms, asset allocation is the practice of dividing resources among different categories such as stocks, bonds, mutual funds, investment partnerships, real estate, cash equivalents, gold, and private equity. The theory is that the investor can lessen risk because each asset class has a different correlation to the others; when stocks rise, for example, bonds often fall. At a time when the stock market begins to fall, real estate may begin to generate above-average returns.
The amount of an investor’s total portfolio placed in each class is determined by an asset allocation model. These models are designed to reflect the personal goals and risk tolerance of the investor. Furthermore, individual asset classes can be sub-divided into sectors. (For example, if the asset allocation model calls for 40% of the total portfolio to be invested in stocks, the portfolio manager may recommend different allocations within the field of stocks, such as recommending a certain percentage in large-cap, mid-cap, banking, or manufacturing.)
- Asset allocation may be determined by age—younger investors can take more risk to grow wealth, while older investors make safer bets to preserve wealth.
- Most asset allocation models fall somewhere among four objectives: preservation of capital, income, balanced, or growth.
- An investor who is actively engaged in an asset-allocation strategy will find that their needs change as they move through the various stages of life.
Model Determined by Need
Although decades of history have conclusively proven that it is more profitable to be an owner of corporate America (i.e., stocks) rather than a lender to it (i.e., bonds), there are times when equities are unattractive, compared to other asset classes (think late-1999 when stock prices had risen so high that the earnings yields were almost non-existent), or they do not fit with the particular goals or needs of the portfolio owner.
A single older adult, for example, with one million dollars to invest and no other source of income, will want to place a significant portion of their wealth in fixed-income obligations that will generate a steady source of retirement income for the remainder of their life. Their need is not necessarily to increase their net worth but mainly to preserve what they have, while living on the proceeds.
A young corporate employee who is just out of college, however, will be most interested in building wealth. They can afford to ignore market fluctuations, because they don't depend upon their investments to meet day-to-day living expenses. A portfolio that is heavily concentrated in stocks, under reasonable market conditions, is the best option for that type of investor.
Most asset-allocation models fall somewhere among four objectives: preservation of capital, income, balanced, or growth.
Preservation of Capital
Asset-allocation models designed for the preservation of capital are largely for those who expect to use their cash within the next twelve months and do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Investors who plan on paying for college, purchasing a house, or acquiring a business are examples of those who would seek this type of allocation model. Cash and cash equivalents, such as money markets, treasuries, and commercial paper, often compose upwards of 80% of these portfolios. The biggest danger is that the return earned might not keep pace with inflation, eroding purchasing power in real terms.
Portfolios that are designed to generate income for their owners often consist of investment-grade, fixed income obligations of large, profitable corporations, real estate (most often in the form of Real Estate Investment Trusts (REITs), treasury notes, and, to a lesser extent, shares of blue-chip companies with long histories of continuous dividend payments. The typical income-oriented investor is nearing retirement. Another example would be a single parent with small children who is receiving a lump-sum settlement from their partner's life insurance policy and cannot risk losing the principal; although growth would be nice, the need for cash in hand for living expenses is of primary importance.
Halfway between the income and growth asset allocation models is a compromise known as the "balanced portfolio." For most people, the balanced portfolio is the best option, not for financial reasons, but emotionally. Portfolios based on this model attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generate cash as well as appreciate over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed-income obligations and shares of common stocks in leading corporations, many of which may pay cash dividends. Real estate holdings via REITs are often a component as well. For the most part, a balanced portfolio is always vested (meaning that very little is held in cash or cash equivalents unless the portfolio manager is absolutely convinced that there are no attractive opportunities demonstrating an acceptable level of risk.)
The growth asset-allocation model is designed for those who are just beginning their careers and are interested in building long-term wealth. The assets are not required to generate current income, because the owner is actively employed and living off their salary. Unlike with an income portfolio, the investor is likely to increase their position each year by depositing additional funds. In bull markets, growth portfolios tend to outperform their counterparts significantly; in bear markets, they are the hardest hit. For the most part, up to 100% of a growth modeled portfolio can be invested in common stocks, a substantial portion of which might not pay dividends. Portfolio managers often like to include an international equity component to expose the investor to economies other than the United States.
Changing With the Times
An investor who is actively engaged in an asset-allocation strategy will find that their needs change as they move through the various stages of life. For that reason, some professional money managers recommend switching over a portion of your assets to a different model several years prior to making major life changes. An investor who is ten years away from retirement, for example, may move 10% of their holdings into an income-oriented allocation model each year. By the time they retire, the entire portfolio will reflect their new objectives.
The Rebalancing Controversy
One of the most popular practices on Wall Street is “rebalancing” a portfolio. This often happens because one particular asset class or investment has advanced substantially, coming to represent a significant portion of the investor’s wealth. To bring the portfolio back into balance with the originally prescribed model, the portfolio manager will sell off a portion of the appreciated asset and reinvest the proceeds. Famed mutual fund manager Peter Lynch calls this practice, “cutting the flowers and watering the weeds.”
What is the average investor to do? If the fundamentals have not changed, and an investment still seems attractive, it may be smart to keep it. On the other hand, there have been cases like Worldcom and Enron where investors have lost everything.
Perhaps the best advice is only to hold an outperforming position if you are capable of evaluating the business operationally, are convinced that the fundamentals are still attractive, believe that the company has a significant competitive advantage, and are comfortable with the increased dependence upon the performance of a single investment. If you are unable or unwilling to commit to these criteria, you may be better served by rebalancing.
Many investors believe that merely diversifying one’s assets to the prescribed allocation model will alleviate the need to exercise discretion in choosing individual stocks. That is a dangerous fallacy. Investors who are not capable of evaluating a business quantitatively or qualitatively must make it absolutely clear to their portfolio manager that they are interested only in defensively selected investments, regardless of age or wealth level.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.