What Is Asset Allocation? Models and Different Classes
Asset allocation is how much money you put into each of the investment categories. These groups include stocks, bonds, real estate, and other asset classes. Asset allocation is one of the most critical determinants of your portfolio's success according to research. It will diversify your portfolio, giving you the highest return with the least risk over time. That's how you outperform the market.
Here's an example.
Say you had cashed out your 401(k) in 2005 and put it all into a house. That would not be diversified since it was 100 percent in real estate. As a result, by 2008 you lost half of the value as housing prices plummeting. If instead, you had equal amounts of your wealth in stocks, bonds, and home equity, you would have only lost 30 percent.
Asset Allocation Models
How much should you allocate to each asset? It depends on three factors:
- Your investment goals: Are you planning for retirement, retired already, or saving for a downpayment on a house?
- Time horizon: How long will it be before you need the money?
- Risk tolerance: Can you stand to watch your investments plummet at times knowing that, in the long run, you'll receive a higher return?
Here are examples:
|Investment Goal||Time Horizon||Risk Tolerance|
|Saving for Downpayment||Short||Low|
Your goals, time horizon, and risk tolerance will determine the model you should use.
If you can tolerate high risk to obtain a high return, you'll put more into stocks and mutual funds. Those with a low-risk tolerance will stick with bonds. Those with zero risk tolerance, or who need their money within the next year, should have more cash.
If you have a long time horizon, then you can afford to put more into your house and watch it grow.
Until the 2008 financial crisis, housing prices rarely fell. If you have a short time horizon, then put more into bonds or even cash.
Each asset class offers different degrees of risk and reward. Here are the three most common asset classes, ranked from least risky to the riskiest:
- Cash: Least risky, but the return is negative once you've taken out the cost of inflation. Money market funds and certificates of deposit are in this category.
- Bonds: There many types of bonds, but they are all fixed-income investments. The safest are U.S. Treasury bonds. They are 100 percent guaranteed by the federal government and offer a slightly higher return than cash. State and municipal bonds offer slightly greater risk and reward. Corporate bonds offer a greater return, but you also have a bigger risk that they'll default. That's especially true for junk bonds. You should also look at international bonds, including emerging markets, as well as domestic.
- Stocks: These are riskier than bonds because you can lose 100 percent of your investment. Over time, stocks offer the greatest return and will outpace inflation. Within stocks, there are three sub-categories based on how large the capitalization is: small cap, mid cap, and large cap. Like bonds, you should have some international and emerging market stocks as well as domestic.
There are many other classes that you should also consider:
- Real estate: This includes the equity in your home, which most financial advisers don't count because you live in it. But the value could deteriorate. You would lose all your investment if you foreclose. It can also skyrocket, forcing you to have too much in this one asset class.
- Derivatives: These offer the highest risk and returns. Keep in mind you can lose MORE than your investment.
- Commodities: Risk can vary because there are so many types. However, most investors should own shares of an oil-related mutual fund. It should rise over the long-term as supplies dwindle. You should have no more than 10 percent of allocation in gold.
- Currencies: As the dollar declines over the long-term, it's good to have assets denominated in foreign currencies such as the euro. It protects you against declines in the dollar. For example, when the dollar is weak, then the euro is strong. The two mixed economies are the same size, so they compete with each other in the forex market.
Strategic Versus Tactical Asset Allocation
Your goals, time horizon, and tolerance risk determine your strategic asset allocation. Once you decide on your strategic allocation, the percent of your portfolio in each asset class will remain the same. You don't change your strategic allocation unless your goals, time horizon, or risk tolerance changes. Every six to twelve months you review your portfolio. You may need to add or subtract to different asset classes to regain your planned asset allocation. If stocks rose 20 percent you will be overweight in stocks. You'd need to sell some and buy bonds.
Here's an example of when you might change your strategic allocation. Most investors' risk tolerance dropped after the 2008 financial crisis. Until then, most people hadn't experienced the devastating losses. They vowed they would never incur them again. Your strategic allocation changes as your age, and your time horizon becomes shorter.
Tactical asset allocation is where you re-adjust your portfolio in response to changing market conditions. It requires more involvement and is riskier. For example, when oil prices fell in 2014 and 2015, a tactical asset allocation might be overweight commodities. The investor would expect that prices would rebound. Only experienced investors should try tactical asset allocation.