The Basics of Portfolio Allocation
by Charles Rotblut, CFA
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.
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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 bonds, 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 ETFs. 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 withdrawal time and 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 An investor with a low risk tolerance (shorter period until the money will be withdrawn and lesser wealth) should follow a strategy that places a greater emphasis on income and capital preservation. An investor with a higher risk tolerance (a longer period until the money will be withdrawn and greater wealth) should follow a strategy focused more on increasing wealth.
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Discussion
Is there a dynamic assest allocation model where there are different buckets with different risks. Then there are different rules that guide when more assets can be moved to higher risk alternatives.
Sorry caught the concept in passing and can't relocate the references. Maybe you can help.
posted over 2 years ago by Mary from California
Asset Allocation is fine, however, the less money you have less avenues are available. AAII continually uses portfolios above $250K or more in its examples.
Always try your models on portfolios of $75K or less and see if they apply.
How does asset allocation work in a depression (the same terms used this time to describe the economic downturn are similar or exactly as those used in the 1929 downturn) when millions of people have lost significant value?
posted about 1 year ago by John from Georgia
This article is almost useful. What is the rationale for 70% stocks and 30% Income oriented? (I assume we are talking about stocks, Bonds, Mutual Funds or ETFs.) I would love to know so that I could appropriately adjust the risk profile of my portfolio. I have devised and numerically tested a dynamic allocation model based on the S&P 500 Index and a stand in for Long term corporate bonds based on an investment range of 0% to 70% for Stocks, 0% to 30% Bonds and 0% to 100% Money Market funds. I chose 10 moving averages for the S&P 500 and Bonds ranging from 1 Month to 27 months, with the data calculated weekly. The allocation goes like this: this weeks price is greater than what % of the 10 moving averages (this gives a value from 0% to 100%). Taking that number and multiplying it by 70% for stocks and 30% for Bonds I tested this over a 48 year period. One could implement this today with two ETFs, for example SPY and VCLT. Doing this beat a 100% Buy and hold of the S&P 500 by 1% compounded over the 48 years (that is 6.12% Compounded Annual Growth Rate (CAGR) for the S&P 500 Buy & Hold vs 7.22% CAGR for the Dynamic Allocation Model.). Additionally, the maximum drawdown for the Buy and Hold was -56% (in 2009) and the Maximum drawdown for the Dynamic Allocation portfolio was about -17%, 1/3 the drawdown/risk of Buy and Hold. One could conceivably add additional buckets with specified maximum allocations totaling 100%, though I have not done the appropriate numerical experiments to look at this. I have looked at re-balancing periods ranging from weekly to 53 weeks and find that at a few re-balancing periods one under-performs Buy & Hold. The numbers I reported above used a 2 week re-balancing period, though some longer periods give slightly better returns than the 2 week re-balancing at the price of greater portfolio drawdowns/risk. I suggest that the AAII Journal explore these types of strategies.
posted about 1 year ago by Richard from California
John, there will be an article in the March AAII Journal showing the impact of diversification, rebalancing and retirement withdrawals on a $100,000 portfolio. -Charles
posted about 1 year ago by Charles from Illinois
