Posts
Comments
The underlying mechanic that makes asset allocation a powerful tool for any investor, is the idea that best-performing asset varies from year to year (i.e., asset correlation) and is not easily predictable. For instance, your stock investments may do well for several years, but you will eventually run into a slow market or a Bear Market where other assets will outperform stocks.
This difference causes your allocation percentage to diverge from the original target over time, because better performing assets will grow larger as underperforming assets grow smaller relative to each other. Once the allocation no longer aligns with the original target, the investor then rebalance the portfolio to restore the original percentage. This involves selling some of the better performing assets to buy some of the underperforming assets. This is “buy low, sell high” at its best.
When I work on my portfolio asset allocation, there are four different types of allocation that I consider to be the most important.
The traditional method of asset allocation breaks down your investment into four broad categories:
The allocation is usually represented as a pie chart, which is further classified as aggressive, moderate, or conservative based on investor’s risk tolerance level and time horizon.
Graphics from CNN Asset Allocator
Your goal is to choose the right balance between stocks and bonds based on your risk tolerance level and investment time horizon. You can try the CNN Asset Allocator to see what a recommended portfolio looks like.
Another way to view asset allocation is based on the Morningstar Style Box, which divides your investment according to nine categories according to the market capitalization and valuation.
Graphic from Morningstar’s Portfolio X-Ray Tool
Since the traditional asset allocation accounts for market capitalization, the real value of this method is the value versus growth comparison.
It’s important that you do not mistaken “growth” for higher return on investment. Based on the Efficient Market Hypothesis, the market already taken the higher growth rate into account and it is already reflected in the price. A “value” stock could very well turnaround, become favorable, and outperform a “growth” stock. Just like before, it’s not possible to predict if value stocks will outperform growth stocks for any given year. There’s a good article called, Value Versus Growth Monthly Returns that illustrate this concept and explains the image below:
Your goal is to diversify and balance growth versus value so that you are not over invested in one area or another.
The next method deals with sector (or industry) that your investments belong to. The top five sectors based on the S&P 500 are: Energy (16%), Financial Services (14%), Industrial Materials (13%), Healthcare (12%), and Technology Hardware (10%).
Graphic from Morningstar’s Portfolio X-Ray Tool
Your goal is to spread your investments across many sectors, so that you are not over invested in any one sector. This is how you protect your portfolio against catastrophic events, such as the collapse of Dot-com Bubble of early 2000s and Subprime Mortgage Crisis of 2007/2008.
The last type of asset allocation deals with the geographical region of your investments. The top geographical markets includes:
Graphic from Morningstar’s Portfolio X-Ray Tool
In my article How Much Should We Invest Internationally?, I argued that the traditional view of limiting foreign investments below 20% of your total assets is too conservative and we should be aiming for 30-50% mark. Larry Swedroe concurred with this assessment in the April 2008 issue of the Ask The Expert article:
I believe investors should consider having 50 percent of their equities in international stocks and have at least 30 percent.
Your goal is to spread your investments across geopolitical boundaries and position your portfolio to capture the growth potential of developing markets, while balancing it with the relative security of matured markets.
Figuring out your ideal asset allocation is a very personal thing, and there is no right answer. When determining your asset allocation, the two most important factors are your risk tolerance level and your investment time horizon.
One way to help you determine your ideal asset allocation is to first look at how much you need to have and how soon. Also, you need to determine if you could afford to wait a few more years if you don’t achieve your goal within the target deadline.
For example, let’s assume you need to save $100,000 for a down payment in 5 years, and can afford to save $1,200 a month for the next 60 months. If you calculate these numbers, your investments must have a combined average annual return of 12% per year. This requires an aggressive portfolio, but 5 years is a short time and you could lose some or all of your money.
Your possible alternatives are:
Now that you understand what portfolio rate of return need to be at, you could more realistically decide your asset allocation. For example, if you are shooting for a 5% rate of return, you could construct a conservative portfolio. However, if you are shooting for a 12% rate of return, you will have to be more aggressive.
Aside from the three main concepts above, there are other factors that you need to consider in your asset allocation strategy.
Although asset allocation supposed to make performance of individual investments less important, it is still a factor. When choosing stocks, you should perform your due diligence and understand the underlying fundamentals. A more effective way of construct a diversified portfolio is through the use of mutual funds and ETFs; preferably passively managed ones because the underlying assets are more predictable and their lower expenses.
Moreover, traditional asset allocation model only mentions stocks and bonds. But you are not limited to just these assets. There are many types of investment that you can use to build your portfolio — e.g., high yield savings, CDs, money markets, whole life insurance, bonds, treasury securities, REITs, futures, options, etc.
When you are building a portfolio, it’s possible that you will be carrying out several transactions per year — i.e., adding new fund and rebalancing your portfolio. As such, it’s important to choose the right investment vehicles to keep your expenses as low as possible, because the impact of high expenses could be significant.
Another term you should understand is asset correlation. The power of asset allocation depends on having a combination of investments that have low correlation. This means that if a group of your investment is doing well, another group won’t — but this means your entire portfolio won’t tank at the same time and you’ll be able to rebalance to buy low, sell high.
Graphic from Stock Market Cook Book
Let’s take a look at the table above. You can see that Large Stocks has a correlation coefficient of -0.02 compare to Treasury Bills. This means that when Large Stocks go up in value, Treasury Bills go down. On the other hand, Large Stocks and Small Stocks with a correlation coefficient of 0.79 will track each other well but not perfectly.
In other word, you can think of Bonds and Treasury Bills as insurance policy against declining stock market condition for your stock investments.
This is where the magic happens with asset allocation. When your allocation shifted from it’s original percentage, you are selling some of the assets that have been doing well and use that proceed to buy more shares of assets that have been underperforming to restore the original percentages. This is basically a “buy low, sell high” technique.
However, you don’t want to rebalance your portfolio too often because you’ll have to deal with transactional expenses and taxes. It’s recommended that you rebalance your portfolio at least once a year and no more than once a quarter. Instead of rebalancing based on time period, a better strategy is to rebalance when the portfolio is a few percentages different from the original allocation.
A strategy that you can use to reduce trading costs and tax consequences is to slowly adjust your portfolio using new funds to buy more of the underperforming assets. This should bring things back into the proper allocation for a smaller portfolio. This technique may not be adequate for a larger portfolio.
Depending on your goal, you could have a portfolio that will last for several decades. As you grow older, your risk tolerance level and investment time horizon will change. Every few years, you should carefully reconsider your asset allocation against your financial goal to make sure they are still in agreement. Often, you’ll find that investors shift toward a more conservative portfolio as they grow older.
Another factor is the tax consequences of your investment activities. How you manage your portfolio, the types of investment, and the nature of the account (i.e., taxable versus tax-sheltered) could have an impact on your investment performance.
Some strategies to consider with regard to taxes include:
If all these asset allocation ideas are giving you a headache, you may be a good candidate for target retirement fund. With target retirement fund, all you have to do is pick the one that has a target date closest to your financial goal
This article was featured in:
1 comment:
Then don't say anything you idiot!....What a joke you are.
Post a Comment