Asset allocation is essential to investment success. In fact, asset allocation has a larger impact on a portfolio’s total return than individual stock selection. In 2000, renowned economists, Paul Kaplan and Roger Ibbotson, published a study concluding that over 90% of long-term portfolio returns resulted from asset allocation. They conducted the study for institutional investors, nevertheless it’s important for individual investors to understand the important role that specific asset composition plays in the long-term returns of their portfolios.
The goal of asset allocation strategy is to balance risk and reward, an inevitable tradeoff for any investor. The idea is to divide the assets in a portfolio based on the individual’s life goals, risk tolerance and time horizon. There are three main asset classes: equity, fixed-income, and cash. Each has different levels of risk and market volatility.
Determining Asset Allocation
In the real world, there is no set formula for determining one optimal formula for asset allocation. It depends on the individual. However, most professional financial advisors concur that asset allocation is the foundation of building an investment portfolio. It’s a key decision – selecting specific securities is secondary. The main determinant of your investment results is the percentage allocation to equity, fixed income and cash.
Personal objectives will also impact asset allocation decisions. For example, someone saving for a down payment for a home in the coming year should have a larger portion of cash and cash-equivalent assets than they might otherwise. This reflects a higher need for liquidity, a shorter time horizon and a lower risk tolerance. They could hold cash, treasury bills and short-term G.I.C.’s. A different example would be someone saving for retirement that is a long way off. This investor has a longer time horizon and may tolerate more risk to achieve greater returns. Risk tolerance is a relative term, and regardless of someone’s age and income, everyone has a different comfort level for risk and market volatility.
Age-Related Asset Allocation
As a rule of thumb, it’s recommended that one should place assets in equities for time horizons of a minimum of five years. Objectives of less than a year out are best met by cash and cash equivalents, like T-Bills and money market accounts. Bonds and other fixed-income products can be used both in between and long-term. In the old days, stockbrokers had a simplistic formula for determining asset allocation: they would subtract a client’s age from 100 to determine the percentage allocation to equity. For instance, a 45-year-old would have 55% of their portfolio invested in stock. Some now base this strategy on subtracting from 105 or 110, as life expectancies rise, but the concept remains the same. The basic reasoning is sound – as people approach retirement age, their investments should move towards increased security and income generation. They trade off growth for safety since they have less working years to make up for losses.
The financial industry has developed products that give investors statistically predetermined ‘age-appropriate’ asset classes. They may call them asset-allocation funds, target-date funds or life-cycle funds. Theoretically, they automatically adjust as the client matures through different life-cycles to match risk levels and investment objectives with the ideal percentage of each asset class. These types of investments definitely have a place in the financial industry and have the potential to improve with AI integration. However, they aren’t an ideal solution since they don’t take into account the many personal details that a professional investment plan should reflect.