The Basics of Portfolio Allocation
How you allocate your portfolio is the most important investment decision you will make. Both the asset classes you choose to invest in and the proportion of your portfolio allocated to each class will be the primary determinant as to whether you achieve your financial goals or not.
In this month’s column, I explain what portfolio allocation is and give you basic starting points based on your risk tolerance.
What Is Portfolio Allocation?
Portfolio allocation encompasses the classes of assets included in a portfolio and the proportion of investment dollars assigned to each asset class. An asset class is a broad category of related securities. Asset classes include equities (stocks), fixed income, commodities (gold, oil, etc.), real estate and alternative investments (venture capital, etc.). Within each asset class are various types of investments. For example, equities encompass individual stocks, stock options, stock-based mutual funds and stock-based exchange-traded funds . The key concept to remember is that an asset class is a broad category covering many types of assets.
Portfolio allocation involves determining what percentage of a portfolio should be allocated to each asset class. These decisions are based on when the money will be needed for withdrawaland the size of the portfolio (wealth). An investor with a low risk tolerance (shorter period until the money will be withdrawn and lesser wealth) should follow a strategy that places a greater emphasis on income and capital preservation. An investor with a higher risk tolerance (a longer period until the money will be withdrawn and greater wealth) should follow a strategy focused more on increasing wealth.
Asset Classes and Diversification
Each asset class has its own, unique return profile. Equities are considered to be more of an aggressive type of asset because historically they have produced higher returns, but they have also encountered bigger fluctuations in value. Fixed income is considered to be more conservative, because bonds tend to pay a steady stream of income, fluctuate less in value and typically return an investors’ money at a predetermined date. (However, no bond is guaranteed to return the amount invested.) Commodities and real estate often produce returns that are different than either stocks or bonds.
An allocation strategy seeks to use the characteristics of each asset class to help an investor reach his goal. For example, an investor with a low tolerance for risk may be primarily focused on preserving capital. As a result, he would allocate a greater proportion of his portfolio to bonds and other fixed-income investments. Conversely, an investor with a high risk tolerance will want a greater proportion of his portfolio allocated to equities.
In either case, investors should not allocate their portfolios solely to one single asset class, but rather to a combination of asset classes. The reason is that an investor should never have all of his eggs in one basket. A portfolio solely allocated to fixed income may not grow enough to keep up with the pace of inflation. This means the investor is at risk of losing purchasing power. (As inflation occurs, a dollar buys fewer goods, meaning it has less purchasing power.) A portfolio solely allocated to equities may be adversely affected by a bear market, such as the one we recently experienced. This puts the investor at risk of losing part of his wealth.
Diversification seeks to reduce this risk. By combining various asset classes, an investor increases the odds of having a portion of his portfolio allocated to the “right” asset class at the “right” time. In other words, as one asset class drops in value, another may rise. This is what happened during the recent bear market when stock prices fell, but the value of U.S. Treasuries increased.
Selecting Asset Classes
How do you know what asset class to be invested in? The answer depends on your risk tolerance and financial goals. A general rule of thumb is that the lower your risk tolerance, the greater the percentage of your portfolio that should be allocated to fixed income (particularly U.S. Treasuries and top-rated corporate bonds).
On AAII.com, we have model portfolio allocations for investors with high, moderate and low risk tolerances (visit www.aaii.com/asset-allocation). Investors with lower risk tolerances (“conservative”) should consider allocating at least 50% of their portfolios to bonds and the remainder to stocks. Investors with higher risk tolerances (“aggressive”) should consider allocating 70% of their portfolios to stocks and the remainder to fixed income.
Keep in mind that these are just benchmarks to use as a starting point. Your own financial plan may require a more conservative allocation (bigger percentage of fixed income) or a more aggressive allocation (bigger percentage of stocks). Furthermore, investors with long time horizons and higher risk tolerances may want to consider allocating a small percentage to real estate and commodities to provide additional diversification.
See the April 2010 AAII Journal for the first article in the Beginning Investor series, “How to Start.”