June 7, 2024
The Key to Long-Term Gains: Smart Asset Allocation Explained
Asset allocation is the primary driver of long-term investment performance. So, what exactly is asset allocation? It is simply the mix between major investment types in a portfolio, including equity (stocks), fixed income (bonds), cash, and alternative assets (basically a catch-all for everything else). The mix between those major asset types plays a large role in the amount of risk, or volatility, in a portfolio as well as the expected returns. Determining asset allocation is one of the first decisions you must make before investing in an account. Although there are some “cookie-cutter” approaches, such as 100 minus age = stock allocation, or sticking with a 60/40, finding the right mix takes more thoughtful consideration. In this article, I will discuss the factors that go into deciding your optimal asset allocation, and why it’s appropriate to revisit the discussion on a regular basis.
Financial Goals
One of the first questions we ask when meeting with clients is: “What do you want your money to do for you?” It prompts individuals to think about what is truly important for them, such as enjoying a comfortable retirement, purchasing a home, paying off debt, or saving for their grandkid’s college education. Having a conversation surrounding financial goals, both short and long-term, allows us to plan out a roadmap of how you will use your savings in the future. Goal-based investment planning means that your savings are growing for specific purposes and supporting future causes. Having clearly defined goals is the first step in building an asset allocation decision.
Risk Tolerance
Risk tolerance is another crucial component of determining asset allocation. This is simply defined as your comfort level with market volatility. While a 60% equity/40% fixed income portfolio has historically returned around 8% annually, every year will look different based on the current market and economic conditions. For example, in 2022, a 60/40 portfolio declined -13.5% alone, while in 2023, there was a recovery of +15.6%. Although market drawdowns are uncomfortable, it’s important to understand if you can emotionally withstand a year like 2022 in order to benefit from a recovery just 12 months later. The worst thing that can happen is to sell your investments when the market has taken a tumble and remain in cash while a recovery takes place. Every investor wants desirable investment returns. However, the higher the expected return in the long-term, the higher the expected risk in the short term. Understanding your tolerance for risk is an important step in determining the right mix between higher risk and return assets, like stocks, and lower risk and return assets, like bonds and cash equivalents.
Time Horizon
Time horizon ties in with financial goals. It is simply when you need funds from your portfolio, rather than how you use the funds. For example, if you want to fully fund a 529 plan for your 5-year-old son, and you expect him to attend college at age 18, then your time horizon is 13 years. When it comes to retirement planning, a person in their 30s has a much longer time horizon than someone in their 60s for their retirement funds. A longer time horizon gives the portfolio an opportunity to recover from market drawdowns and benefit from the power of compounding, especially without the burden of withdrawals during challenging periods. Understanding your time horizon can help us orient the portfolio towards growth or income generation depending on the answer.
Risk Ability
Determining your ability to take risk ties in your goals as well as your time horizon. An example of an individual that has a high ability to take risk wants their portfolio to grow, has a long time horizon before retirement, and is not withdrawing from their portfolio. However, another individual who wants their portfolio to grow and is currently spending down their portfolio in retirement has a much lower ability to take risk. This is due to the demand on capital of the portfolio. In retirement, you may not have the ability to reduce portfolio distributions in the event of a large market drawdown. Regular portfolio distributions may be necessary for paying bills, insurance premiums, and other expenses. Even with a high-risk tolerance, your ability to take on risk may be limited by your time horizon or current needs.
Summary
Determining asset allocation involves a strong understanding of your goals, risk tolerance, time horizon, and risk ability. Over time, all of these different components will change. At least annually, it’s important to review progress on your goals, determine if your emotional tolerance towards risk has changed, update your time horizon, and reevaluate your ability to take on investment risk. While the headlines in the newspaper should not dictate your optimal target asset allocation, the headlines in your life certainly will (e.g. loss of a job, death of a spouse, birth of a child, change in health, and so on). As advisors, we enjoy facilitating these conversations and asking meaningful and thought-provoking questions to help guide you in making investment decisions that fit your lifestyle.