An often overlooked financial principle is that of asset allocation or ‘AA’ as it’s commonly referred. No, it’s not the same as alcoholics anonymous. Although, if you ignore your AA for long enough you may be pushed to drink a little too much. If you’ve already bolstered your savings rate, you’ll certainly want to read up on AA as they go hand-in-hand!
What is asset allocation?
According to Investopedia, “Asset allocation is 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.”
That’s a lot of words. In short, AA refers to how you split your investments among different asset classes. The list isn’t limited to the above, and can also include things like real estate, gold/silver, art, and other valuable items.
“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”James Chen, Investopedia
Why asset allocation is important
Asset allocation is a huge part of your overall financial plan. The totality of your entire portfolio needs to adequately address your goals, risk tolerance, and personal financial situation.
As you start on your investing journey, I challenge you to determine your personal risk tolerance. As a general rule, younger individuals will have a higher risk tolerance due to the longer investing timeframe, and older individuals will have a lower risk tolerance due to being closer to retirement. As you probably guessed, there are a ton of different AAs that can be deployed in between these two scenarios.
Rules of thumb
Rule #1 of AA: there is no rule of thumb. Everyone’s situation is different, and every plan should be developed with the individual(s) in mind. Don’t feel pressured to conform to a specific AA because your buddy is doing it or because you heard it on the news. Do a little bit of research (on Wealthy Idiots!) and find out what works for you!
You’ll hear “rules” such as “Age minus 10 in bonds”, which equates to the percentage of your portfolio you should always hold in bonds. But again, this is largely personal and shouldn’t be looked at as a hard rule. Rule #2 of AA: there is no rule of thumb (insert Fight Club reference here).
Example of asset allocation
So you’re probably wondering what this looks like in practice and I think we can help you out. For simplicity sake, let’s look at two different people: Joe, who is 35 years old and has a $1M portfolio, and Jane, who is 57 years old and has a $2M portfolio.
Joe is likely to be a little more risky in his investment strategies. It wouldn’t be unusual to see Joe’s AA look something like this: 80% stocks, 10% real estate, 10% bonds. This would mean Joe is currently holding $800k in stocks, $100k in RE, and $100k in bonds. Not a bad portfolio for the long-term.
Jane on the other hand is likely to be more conservative. She could have a portfolio of 60% stocks, 30% bonds, and 10% cash. This would give her $600k in the stock market, $300k in the bond market, and 10% in cash-equivalent holdings. Pretty conservative portfolio overall.
Obviously these strategies vary on so many factors. For instance, if you have a pension you may hold more stocks throughout your entire life, or maybe your house is paid off approaching retirement, so you’re less worried about market fluctuations. Either way, these strategies should be tailored to the individual risk tolerance, short and long-term investing goals, and personal preference.
I always try to give my own investment strategy so everyone can see a live example of how this works.
I currently hold 60% stocks and 40% real estate. Yup, that’s it. Granted, I have a couple grand in cash, but it’s such a small number that I don’t include it in my AA. As I continue to invest each year, I expect the stock % to increase while the RE value dips slightly, but who knows. I try not to predict the future too much.
Either way, make sure you pick a strategy and stick to it. Don’t just keep saving without a goal or purpose!