Asset allocation is an investment strategy that adjusts the percentage of each holding in an investment portfolio according to the investor's risk tolerance, goals and investment time frame.
One famous industry study indicated that over 90% of the return from an investment portfolio was attributable to the portfolio’s asset allocation. While some have questioned whether or not the percentage is actually this high, there is little question that your portfolio’s asset allocation is a critical factor in determining your return.
Here are some thoughts as to why asset allocation is so important to your investment portfolio.
A key factor in any sound investment strategy is a strong consideration of the investor’s risk tolerance. This might be tied to their age, time horizon, or if the portfolio is needed for a specific goal like retirement.
Asset allocation is a tool to balance the management of the portfolio’s potential downside risk with its potential return through the appropriate allocation to holdings in various asset classes.
One of the basic tenets of long-term investing is portfolio diversification. In a nutshell this means holding a variety of investments that are not all highly correlated to each other. Asset allocation is the most efficient way to set up an investment strategy that accomplishes this for our clients.
For example, bonds have a correlation of -0.20 to U.S. large cap stocks. A correlation of 1.00 would mean that these asset classes were perfectly correlated to each other. A perfect correlation means that the price movements of holdings in the two asset classes would move roughly in lockstep with each other and that these price movements would be influenced by the same market and economic factors.
On the other hand, a correlation of 0.00 would indicate little or no correlation in the price movement or in the factors that influence these price movements.
In the example above, there is a very low correlation between the two asset classes. Additionally, the negative correlation indicates that factors that might push one asset class higher would tend to push holdings in the other asset class lower. As we’ve seen over time, bonds tend to hold up better than equities when the stock market is experiencing a period of correction.
Certain asset classes and individual holdings will outperform others at different points in time. Having a target asset allocation helps investors in that it provides a “starting point” so to speak. A key piece of the portfolio review process is a review of your asset allocation. Is it still in line with your portfolio’s target asset allocation?
Reviewing your portfolio periodically is important. This is typically done quarterly. We discourage clients from looking at their portfolios daily and we feel that rebalancing too frequently may do more harm than good. Reacting to every movement in the market is at odds with the benefits of taking a long-term approach to investing.
Many advisors set a range for the various asset classes within a client’s portfolio. If an asset class falls outside of that range then they will rebalance those holdings back to within the target range. A range of +/- 5 percentage points deviation for the target is common for many advisors.
It’s human nature to want to let an investment that has recorded large gains keep running. This may be fine for a period of time, but invariably these gains will level off or be reduced when the holding turns around and gives some or all of those gains back.
The discipline that an asset allocation target brings to investing is that as one or more asset classes grows to a level that exceeds the target allocation by the stated percentage, a portion of the holdings in this asset class are then sold to bring the overall asset allocation back to within the target allocation range. This helps maintain the balance between the portfolio’s upside potential and it’s downside risk.
Many investors have multiple accounts of different types. This might include taxable accounts, IRAs, a 401(k) or similar workplace retirement account or others. The retirement accounts may be traditional, Roth or both.
While the asset allocation of the various accounts may differ a bit, taking a total portfolio approach to asset allocation is important. This helps you focus on the overall level of investing risk you are taking.
A part of a total portfolio approach includes paying attention to asset location as part of this process. Certain types of investment assets are more tax-efficient if held in one type of account versus another.
For example, stocks or equity ETFs or mutual funds that you plan to hold for a period longer than one year are a good fit for a taxable account due to the preferential tax treatment of long-term capital gains. Taxable bonds, including ETFs and mutual funds that invest in them, may be a better fit for an IRA or other tax-deferred (or tax-free in the case of a Roth) retirement account due to the level of fully taxable income they throw off each year.
Asset allocation is meant to be a target that you try to maintain over time. As a key part of the overall financial planning process, your target asset allocation provides a base point for rebalancing over time when the markets move in one direction or another.
Over time, your target asset allocation will likely change as part of the ongoing financial planning process. As you get older an asset allocation that takes less risk might be appropriate for you. You might also adjust your asset allocation to take less risk if your portfolio performs exceptionally well over a several year period. You may find that you are farther along towards accumulating the amount needed to achieve your goals than your financial plan had called for.
Asset allocation is perhaps the most important part of crafting and implementing an investment strategy. It is also an integral part of your overall financial planning efforts.
If you are looking for a fee-only fiduciary financial advisor who will always put your interests first, please give us a call to discuss your portfolio’s asset allocation or any other financial issues. We are here to help.
Bill Canty, CFP®, CPA
Ed Canty, CFP®, Investment Advisor
Joe Canty, Investment Advisor
Maureen Walsh, EA, Investment Advisor
Tina Alteri, CPA, Tax Advisor