I was doing some research today when I came across a great piece from Vanguard that really emphasized just how important the idea of asset allocation is to individual investors. There isn’t one answer, like put X% in stocks and Y% in bonds, so it makes the topic more of an art form than a science project. Not everyone should have the same asset allocation as it is a function of risk and necessity (as defined below), however, regardless of whether you are handing your own investments, or you have a financial professional, you should understand the idea of asset allocation and the historical returns on various allocations.
What is Asset Allocation?
Investopedia provides a decent definition for asset allocation,
An investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.
INVESTOPEDIA EXPLAINS ‘Asset Allocation’
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 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.
To boil it down even further it is determining how much of your money is going to be in cash, bonds and stocks while considering your risk tolerance and time horizon. As shown below, if you are going to retire in 6 months you need to have a different asset allocation than someone like myself that has decades, even if we can stomach the same ups and downs.
Some Historical Returns of Various Asset Allocations
When I was asked to do this research I assumed correctly that Vanguard would be a fantastic place to start, and I wasn’t wrong. Vangaurd provides high and low returns along with average from a pretty significant time horizon:
As it is easily seen, as you move from left (100% bonds) to right (100% stocks) the gap between best and worst year is getting larger. That gap can be seen as volatility and one has to decide whether their heart and stomach can handle the extra 4% on both swings for .5% gain when you are comparing 50/50 and what is presumably 60/40…or in Vanguard’s words,
Stocks are inherently more volatile than investments such as bonds or cash instruments. This is because equity owners are the first to realize losses stemming from business risk, while bond owners are the last. In addition, whereas bond holders are contractually promised a stated payment, equity holders own a claim on future earnings. But the level of those earnings, and how the company will use them, are beyond the investor’s control. Investors thus must be enticed to participate in a company’s uncertain future, and the “carrot” that entices them is higher expected or potential return over time.
The chart below also demonstrates the short-term risk of owning stocks: Even a portfolio with only half its assets in stocks would have lost more than 20% of its overall value in at least one year. Why not simply minimize the possibility of loss and finance all goals using low-risk investments? Because the attempt to escape market volatility associated with stock investments by investing in more stable, but lower-returning, assets such as Treasury bills can expose a portfolio to other, longer-term risks.
Again, there is no right or wrong, but rather just understanding the concept (and taking appropriate measures) is vital regardless of whether you are handling your own investments or have a professional who may not be investing with your risk tolerance in mind.