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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 determinants of whether or not you achieve your financial goals.
What Is Asset Allocation?
Asset allocation involves assigning a proportion of investment dollars to specific asset classes. An asset class is a broad category of related securities, such as equities (stocks), bonds, commodities (gold, oil, etc.), real estate and even alternative investments such as venture capital or cryptocurrency. Of these, the three that are considered key building blocks to a successful allocation strategy are stocks, bonds and cash. Naturally, each asset class has various types of investments. The equities asset class, for instance, includes stocks, options, mutual funds and exchange-traded funds (ETFs).
These asset classes have different risk profiles and historical rates of return. The blend you choose significantly affects your expected growth, but also affects the likelihood of experiencing a given year with a substantial portfolio decrease. Investors diversify in this way (between and within asset classes) to protect gains while still gaining exposure to market price movements. There is no universal best asset allocation strategy because portfolio goals vary for each investor.
For more on the basics of asset allocation, see the box below.
Selecting Asset Classes
How do you know which asset classes 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 60% of their portfolios to bonds and the remainder to stocks. Investors with higher risk tolerances (“aggressive”) should consider allocating 90% 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.
Deciding on Your Asset Allocation
Once you’ve determined what kind of investor you are (conservative, moderate or aggressive), it is time to focus your energy on the nuts and bolts of the asset allocation process. In other words, it’s time to slice up the stock and bond pies into allocations across specific investment categories: large, mid, small and international stock holdings, plus determining how many intermediate- or short-term bonds you want to own.
On the AAII.com Asset Allocation Model page, you have access to suggested asset allocation breakdowns for these categories based on the type of investor you are. We also provide mutual funds and ETFs that represent each of these asset classes.
Analyzing Your Asset Allocation With My Portfolio
Although asset allocation has a significant impact on your portfolio’s performance, many investors struggle with questions of whether they are holding the right investments in the right proportion to one another.
You may—like other investors—own stocks, mutual funds and/or ETFs. Individually buying each may have made sense at the time of purchase, but do you know how well they fit together? Is there a chance you have too much exposure to a small number of sectors while unintentionally ignoring others? What about market capitalizations? Do you have any exposure to small-cap stocks? Is it more or less exposure than you think? Does your portfolio’s allocation make sense given the type of investor you are?
What about the attractiveness of your investments? Are the stocks you hold still attractively valued? Are they still the growth-type stocks they were when you bought them? What about your mutual funds and ETFs? Are they still good investments or should you start looking at their competitors?
Doing the analysis to figure out the answers may seem daunting at first. Fortunately, it doesn’t have to be. AAII’s My Portfolio offers AAII members and A+ Investor subscribers analysis tools that give you the information to make the important decisions about your portfolio.
The first step to unlocking the full power of My Portfolio is setting up a portfolio at www.aaii.com/myportfolio.
Just select Create and start adding tickers. A user’s guide is available if needed at www.aaii.com/myportfolio/userguide.
Tools for Making Allocation Decisions
At the top of My Portfolio, you will see several tabs. Each provides specific information about your portfolio.
The Portfolio tab provides an overview of your holdings. You’ll find useful price, gain/loss, valuation and dividend data about your holdings. You can also add any personal notes, such as the reason you purchased a certain stock.
A+ Investor subscribers can quickly judge the attractiveness of their investments with the Grades tab. Stocks, mutual funds and ETFs are assigned a grade of A, B, C, D or F. Just like in school, A’s and B’s are good while D’s and F’s are bad. At a glance, you can see whether your investments still warrant a spot in your portfolio based on the characteristics that matter to you most—for example, for stocks you can quickly pinpoint those with low valuation, strong growth or positive earnings estimate revisions.
Want to learn more about what’s driving the grades? Just click on the ticker symbol. Doing so will take you to the Stock Evaluator, where A+ Investor subscribers can then click on the Grades tab to get more detail for that particular stock. (We also created mutual fund and ETF evaluators, with Grades accessible to all AAII members. Clicking on any ticker symbol in your portfolio will take you to the evaluator for that security.)
The Diversification Analyzer in My Portfolio, also part of A+ Investor, gives you a breakdown of how your portfolio is allocated based on the number of shares you’ve entered for each stock, mutual fund and ETF, plus any dollar amounts you’ve entered for cash and/or bond holdings. This information is used to tell you if you are being too aggressive or not aggressive enough given your chosen investing profile (Figure 1). These designations are based on the AAII Asset Allocation models discussed previously.
In the example in Figure 1, the investor considers themselves to be aggressive. As the Asset Allocation Analyzer shows, the actual portfolio’s allocation may be more aggressive than the investor realizes. It has a very high allocation to equities (nearly 95%), and thus a very low allocation to bonds. However, a truly “aggressive” investor may wish to lower their exposure to domestic stocks in favor of foreign issues.
Diversification is not just limited to stocks, bonds and cash. Diversifying within asset classes can help protect you against security-specific risks. Even when you hold many different investments, you may not be as diversified as you think. This can particularly occur when you hold too many stocks from one sector or just a few sectors. You can also diversify, and even boost your returns, by purposely allocating beyond large-cap stocks.
The Diversification Analyzer gives you a breakdown of your portfolio by sector, size and geography (Figure 2). In the example, the investor is heavily allocated to consumer cyclical and health care stocks. They also have little exposure to several sectors, including basic materials, energy, consumer defensive and utilities.
When focusing on individual stocks, it can also be easy to lose sight of how little exposure you have to stocks of different sizes such as small caps. The Diversification Analyzer makes it easier to catch this. This portfolio is heavily weighted toward large-cap stocks.
Making Smarter Portfolio Decisions
Asset allocation is a critical element of investing, perhaps the most important. It determines risk and expected return—both more so than the individual securities within each asset class. Figuring out the right asset allocation mix for your goals is the first step to achieving them. The AAII tools and resources highlighted here can help you to structure your portfolio to maximize your returns.
Asset Allocation Basics
Dividing capital among the various asset classes depends on your risk appetite and investing timeline. Investors comfortable with risk typically place most of their capital—up to 90%—in stocks, while conservative investors place around 50% of their funds in fixed income. Because of their risk, stocks can offer higher rates of return. Bonds, stable by their nature, generally offer modest returns, especially in today’s low-interest-rate environment.
Risk tolerance largely depends on the investing timeline. Young investors, not needing to draw down their portfolio for decades, should generally invest aggressively. Retired investors tend toward conservatism because they cannot risk a year with a 30% equity crash—they don’t have other income to supplement their portfolio. As the time to retirement decreases, investors tend to shift their asset allocation strategy to move funds from equities to bonds.
Wealth and cash flow also play a role. Those who will be spending a smaller proportion of their wealth or have guaranteed sources of cash flow (such as pension and Social Security benefits for retirees) can opt for a more aggressive allocation. Conversely, those who will be spending a large portion of their savings over a shorter period of time should consider a more conservative allocation.
Asset Allocation by Age
Again, these are general patterns; asset allocation by age varies by individuals’ needs. New investors may need money to buy a home and therefore might opt for a conservative asset allocation model. Those who retire early need their portfolios to last 35+ years, and thus will keep a larger exposure to the stock market.
A simple asset allocation rule to follow is to subtract your age from 100 and invest that amount in stocks. As bond yields have fallen, some retirement planners now argue that the rule should be modified to 110 or even 120. Regardless of which you choose, it gives a good indication of where to invest your funds.
What Is Tactical Asset Allocation?
Tactical asset allocation involves taking an active approach to the percent of a portfolio in any particular asset class based on expected market conditions. For example, a 45 year old may have 60% of her funds invested in equities. However, she expects that stocks will rise in the next five years because of a current recession. Therefore, she chooses to increase her stock asset allocation to 70%.
While this may sound obvious—buy low, sell high—it delves into market timing, which few experts endorse since investors generally overestimate their ability to identify market lows and highs. Instead, financial advisers generally recommend spending time and energy on successfully diversifying holdings within asset classes, not shifting the holding percentage between them in response to market conditions.
This diversification helps maximize returns within asset classes and ensures safe access to money when needed. On the equities side, investors should have exposure to large-cap, mid-cap, small-cap and international (from emerging and established markets) stocks. Aggressive investors tend to have a higher percentage of funds in mid- and small-cap stocks and emerging markets than more conservative counterparts because of risk.
Bond diversification means choosing between short- and medium-term bonds. The longer the term, the higher the yield, but also the higher the risk that the issuer defaults or goes bankrupt. Until investors have a regular need to draw from their portfolio, bond allocation should be entirely in intermediate-term bonds. Generally, only conservative investors should park money in short-term bonds.
Recently, new target-date funds have emerged to simplify the asset allocation process. These funds have a target payout date and automatically adjust exposure to stocks and bonds as the years pass. For instance, someone who buys shares of a 2045 target-date fund (expecting to retire in year 2045) would automatically have their funds diversified appropriately. This benefits individuals who want a more passive approach to investing, but obviously comes with increased expenses and loss of control.
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