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Asset allocation

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Asset allocation, or asset mix, is how a portfolio is divided between asset classes, the three main ones being equities, fixed income, and cash and equivalents. This allocation should reflect the investor's goals, risk tolerance and investment horizon.[1] The main asset classes have different levels of risk and return, so each will behave differently (i.e. they are not perfectly correlated) over different periods and market/economic conditions. Diversifying portfolios across asset classes will help to optimize risk-adjusted returns.[2]

There are a number of asset allocation strategies that can be employed by investors. The common ones are strategic asset allocation and tactical asset allocation.

Investopedia explains "There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors can make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results."[1]

It is widely agreed that asset allocation accounts for a large part of the variability in the return on a typical investor's portfolio.[3]

Asset allocation strategy

There are a several allocation strategies; the common ones are strategic asset allocation and tactical asset allocation. This article primarily discusses strategic asset allocation, which is described in the following sections.

Strategic asset allocation

A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.[4]

Tactical asset allocation

An active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors.[5]

Stay the course: strategic asset allocation

Three quotes from authors of famous investment books illustrate why strategic asset allocation and diversification are important, and why you should not overestimate your risk tolerance, since staying the course over a long period is difficult.

In short, during the next 20 or 30 years, there will be a single, best allocation that in retrospect we will have wished we have owned. The only problem is that we haven't a clue what that portfolio will be. So, the safest course is to own as many asset classes as you can; that way you can be sure of avoiding the catastrophe of holding a portfolio concentrated in the worst ones[6]

A key reason for devising an asset allocation strategy is to help an investor reduce the risk inherent in volatile equity asset classes that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets. These balanced portfolios help reduce volatility and down-side risk, thus better enabling an investor to maintain a long term investment program (stay the course) without panic selling during bear markets.

For most investors, the hardest part is not figuring out the optimal investment policy; it is staying committed to sound investment policy through bull and bear markets and maintaining what Disraeli called "constancy to purpose." Sustaining a long-term focus at market highs or market lows is notoriously difficult. At either market extreme, emotions are strongest when current market action appears most demanding of change and the apparent "facts" seem most compelling.[7]

People tend to overestimate their risk tolerance, especially when stock markets are going up. Here is an analogy illustrating why balanced portfolios (with enough bonds in them) might be likelier to succeed over the very long term, compared to stock-only portfolios:

Over the past four decades, I’ve learned that the prime prerequisite for a successful portfolio is that it survives. (...) The financial markets are a car that conveys your assets across town from your present self to your future self. The roads are slick with ice and studded with giant potholes. If you drive fast, you might indeed get to your destination a lot quicker. But it’s usually a bad idea.[8]

Need, ability, and willingness to take risk

Author Larry Swedroe has written a multi-part guide for selecting your asset allocation; how much to invest in stocks versus bonds, based on your need, ability, and willingness to take risk.[note 1] A similar framework is suggested by a CFA Institute guide intended to help financial advisors define their clients' risk profile.[9]

Need for risk

The need to take risk is determined by the rate of return required to achieve financial objectives.[10] The greater the rate of return needed to achieve one's financial objective, the more risks with equities one needs to take. A critical part of the process is differentiating between real needs and desires.

The following table classifies a person's need to take risk based on the percentage of "growth assets" (typically equities) required to achieve the required rate of return to reach a goal, based on a financial projection:[9]

Growth assets needed Risk need categorization
Less than 30% Low
30-70% Moderate
Greater than 70% High

Risk-taking ability

An investor’s ability to take risk is determined by four factors:[11]

  1. Investment horizon - when do you need the money?
  2. Stability of your earned income
  3. The need for liquidity - if you need the money in a hurry
  4. Options that can be exercised should your existing plan fail to meet your objectives

The following table classifies a person's ability to take risk based on their time horizon and need for liquidity:[9]

Criteria Risk-taking ability
Time horizon 5 years or less, or
annual liquidity need greater
than or equal to 5% of portfolio
value, with no backup plan		 Low
Intermediate situation Moderate
Time horizon 10 years or more and
annual liquidity need less than 5%
and other income or assets available
to maintain standard of living in
case of an emergency		 High

Behavioral loss tolerance

The willingness to take risk should correspond to the investor's actual risk tolerance.[12] Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough?

The "emotional wherewithal to engage in risky financial behaviors" is influenced by:[9]

  1. risk tolerance (willingness to take risk);
  2. risk preference (maximize safety or maximize returns?);
  3. financial knowledge;
  4. investing experience;
  5. risk perception ("subjective evaluation of potential risk-taking outcomes");
  6. risk composure (how did you react during the last bear markets).

Risk tolerance questionaires are a way to assess this. An freely available example is the University of Missouri Investment Risk Tolerance Assesment, which has already been used by over 200 000 respondents.[13][14] The result of that particular test is a score comparing your answers to other respondents: you might have a high, above average, moderate/average, below average or low tolerance for risk.

Putting it all together

That risk tolerance result, combined with the other two aspects (ability and need), is then translated into an overall stock:bond split.[9][15]

Both risk-taking ability and risk tolerance can be seen as limiting factors. For example, if the required rate of return is high, indicating a high need for risk, but the risk-taking ability or risk tolerance are low, going with an all-equity portfolio is not recommended. Instead, the investor could save more, or revise their goals (e.g., work longer) so they are attainable with a lower expected return, allowing a less agressive portfolio that matches their ability and willingness to take risk.[16]

Domestic vs foreign asset classes

Main articles: Global diversification and Home country bias

Once the fixed income:equity split has been decided, a second important – but difficult to answer – question is how much to allocate to foreign (or “global”), as opposed to domestic, asset classes. Canada represents a very small portion of world stocks and bonds and some writers have suggested that based on financial theory, Canadians should therefore have very low allocations to domestic asset classes. In practice, most Canadian investors have much larger allocations to domestic asset classes, ranging up to 100%. This is known as the home country bias, and can be justified by a number of arguments. For fixed income, most investors will in fact opt to keep it all domestic. For equities however, there are convincing arguments for global diversification, including reduced volatilities, and avoiding sector concentration/under-representations in the domestic market, as well as avoiding issuer concentration in the domestic market.

Asset allocation over the life cycle

Main article: Asset allocation over the lifecycle

The "need, ability, and willingness to take risk" framework discussed above lets you arrive at an initial asset allocation. But how should that asset allocation evolve over time? Should it be constant, e.g. a "balanced portfolio" with a 60-40 split between equities and fixed income (mostly bonds), during both accumulation (pre-retirement) and decumulation (after retirement)? Or should the portfolio asset mix evolve, in a planned fashion, over time, i.e. follow a glidepath? Possible strategies include a constant allocation over time; declining equity glidepaths; and rising equity glidepaths.

Rules of thumb

The following "rules of thumb" might be helpful.[note 2]

There is a rule of thumb ("age in bonds") that says subtract your age from 100, where 100 is expected longevity, in order to obtain an equity/bond asset mix. As you age your reliance on your investments will likely increase and thus it is expected that your focus adjusts less towards growth (and its inherent variability) and more towards stability (and its inherent preservation of capital). A 20-year old would have an equity/fixed income asset mix of 100 - 20 = 80 or 80/20. A 60-year old would have an equity/fixed income asset mix of 100 - 60 = 40 or 40/60. This concept is best graphically represented by a human capital graph:[note 3]

Asset Allocation over Time

When you are 20, you have little financial wealth but an entire earning lifetime ahead of you. You can afford to have an aggressive asset allocation, although you may not have the stomach for it. As you age, your financial wealth increases but your remaining earning years decrease and your asset allocation becomes more conservative. Even if the tolerance for risk questionnaire says that you can take an aggressive asset allocation, you shouldn't. You need to protect your assets because you have no way of replacing them.

As with everything, there are always exceptions. If you have an indexed, defined benefit pension plan that appears secure and that covers your living expenses, then you can afford to take as much or more risk than your risk questionnaire says you can. Understand, though, that everyone's perceived tolerance for risk is far greater than one's actual tolerance for risk. It takes a severe market downturn to prove this point. Bull markets tend to increase the risk profile of a portfolio because one is loathe to reduce an overweight position because it's obviously going to continue to increase in value. Again, it takes a severe market downturn to demonstrate that a tree cannot grow to the sky. If you don't need to take the risk, why do so?

All age-based guidelines are predicated on the assumption that an individual's circumstances mirror the general population's. Individuals with different retirement ages (earlier or later), asset levels, or needs for the money (e.g. saving for a goal other than retirement) would be well-advised to consider what circumstances make their situation different and adjust their asset allocation accordingly.

Benjamin Graham, in "The Intelligent Investor", suggests the following policy:

"We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums."[17]

Rebalancing

Main article: Rebalancing

Over time your asset allocation may change from it's original position as a result of the difference in returns from the various asset classes. Rebalancing is the act of bringing the asset allocation in line with your investment policy statement. A typical recommendation is you should review your asset allocation once a year and if necessary rebalance as specified in your investment policy. Rebalancing is often the most difficult part because it is counterintuitive, it requires you to sell a portion of an investment that went up, and buy more of what went down.[18]

Notes

  1. ^ There are additional articles in the series:

    Part V: Asset Allocation guide: U.S. vs. international equity, CBS Moneywatch, March 4, 2014.
    Determine the appropriate mix between domestic and international stocks. (This article is US focused.)

    Part VI: Asset Allocation Guide: Value vs. growth, CBS Moneywatch, March 13, 2014.
    Decide how much to invest between value and growth stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)

    Part VII: Asset Allocation Guide: Small-cap vs. large-cap, CBS Moneywatch, March 18, 2014.
    Decide how much to invest between small-cap and large-cap stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)
  2. ^ Rule of thumb: A principle with broad application that is not intended to be strictly accurate or reliable for every situation.
  3. ^ Human capital is the measure of an employee's skill set. See:Human Capital, on Investopedia. It can also be defined as "the present value of the anticipated earnings over one’s remaining lifetime" (Ibbotson et al., 2007, Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, Research Foundation of CFA Institute, page 1)

See also

References

  1. ^ a b Asset Allocation Definition | Investopedia, viewed January 6, 2015.
  2. ^ Larrabee, David, Setting the Record Straight on Asset Allocation | Enterprising Investor, CFA Institute, 16 February 2012. Viewed January 6, 2015.
  3. ^ Sharpe WF (1992) Asset Allocation: Management Style and Performance Measurement, Journal of Portfolio Management, Winter 1992, pp. 7-19. Viewed January 5, 2015
  4. ^ Investopedia, Strategic Asset Allocation definition, viewed June 11, 2012.
  5. ^ Investopedia, Tactical Asset Allocation definition, viewed June 11, 2012.
  6. ^ William J. Bernstein, The Four Pillars of Investing, McGraw Hill, p. 244
  7. ^ C.D. Ellis, Winning the Loser's Game, Fifth Edition, McGraw Hill, p. 8.
  8. ^ William Berntein, A Day to Remember, January 15, 2022, viewed January 27, 2022.
  9. ^ a b c d e CFA Institute (2020) Investment risk profiling - a guide for financial advisors, 30 p., viewed February 7, 2025.
  10. ^ Swedroe, Larry, Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
  11. ^ Swedroe, Larry, Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
  12. ^ Swedroe, Larry, Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
  13. ^ Grable JE, Lytton RH (1999) Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review 8:163-181, PDF available from the University of Georgia, viewed February 5, 2025
  14. ^ Kuzniak S et al. (2015) The Grable and Lytton risk-tolerance scale: A 15-year retrospective, Financial Services Review 24:177-192, DOI 10.61190/fsr.v24i2.3240 , viewed February 7, 2025.
  15. ^ Ben Felix, Choosing an Asset Allocation (How Much in Stocks vs. Bonds?), Youtube video dated February 2, 2025, viewed February 5, 2025.
  16. ^ Swedroe, Larry, Asset Allocation Guide: Dealing with conflicting goals, CBS Moneywatch, February 25, 2014.
  17. ^ The Intelligent Investor, Benjamin Graham, Fourth Revised Edition, pg. 41
  18. ^ Ferri, Richard A. (2010). All About Asset Allocation: The Easy Way to Get Started (Second ed.). McGraw-Hill, Inc. p. x. ISBN 978-0071700788.

Further reading

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