The Asset Allocation Decision

Asset allocation is an investment portfolio technique that aims to balance portfolio risk by dividing investable assets among major categories. In a broad sense, is it is the division between investing in income-producing assets--such as bonds and cash, and investing in assets that grow through capital appreciation--such as equities and real estate. Each asset class has different levels of return expectations and risk, as defined by standard deviation. Each asset class behaves differently over time and return expectations modify over time.

Further compounding the issue is the correlation between assets. The correlation of asset classes defines how assets move in relationship to each other. Some asset classes are strongly and positively (as opposed to inversely) correlated; others tend to be less sensitive to one another and are said to be less-correlated. You will find that large-cap stocks, and mid-cap stocks are strongly and positively correlated. Whereas, US Treasury Bonds are negatively correlated to the S&P 500. When you pair Treasuries and large-cap equities together, overall volatility of a given portfolio will trend lower; both of the asset classes have traditionally performed well, but during different time periods.

Asset allocation is the single most important decision an investor will make when looking at portfolio performance. Historically, over 90% of a client’s annual return is influenced by the allocation decision. While I recommend having a thoughtful conversation with a financial professional when determining an appropriate asset allocation for you, there are some common sense approaches to guide you during this decision process.

Many are aware that, historically, allocation guidance was directed by the age of the investor. Conventional wisdom was that your income/bond allocation should equal your age and your growth/equity allocation should be 100% less your bond allocation. With this line of thinking, approximate allocations and investment categories would look like this:

Age 40 Bonds=35%-40%      Equities = 60%-65%      Balanced
Age 55 Bonds =50%-55%      Equities = 45%-50%      Moderate
Age 70 Bonds =65%-70%      Equities = 30%-35%      Conservative

Another approach to derive the best allocation for an investor is having the investor fill out a risk-based questionnaire. The goal is to determine how risk-adverse or comfortable an individual is with the value of their nest-egg fluctuating. The best question I have used in the past that has offered realistic guidance is the following:

“I get really anxious and uncomfortable if my portfolio value drops by more than X_%.

If your answer to the above question is in the 20-25% range, that defines exactly what happened in the typical “balanced asset allocation” portfolio in 2008 when the S&P 500 was down approximately 38% for the year. A “moderate” or “conservative” allocation did not feel that large of the impact of the 2008 sell-off. Looking back at the great recession has provided helpful guidance. Although it was a single-year loss and the subsequent years grew at above-average rates, it is a helpful exercise to understanding where people live on the risk spectrum. It is also a great discussion point and can aid in conceptualizing very “real” investment scenarios.

But honestly, these methods do not always work and a practical approach to asset allocation should also be introduced. Understanding an individual’s goals, as well as the resources needed to achieve those goals is paramount. Sometimes, however, goals, resources and risk tolerance can be misaligned. When putting together a financial plan, we will typically discover shortfalls of the plan. The planning process helps us determine if an individual needs to keep working longer, save more money between now and retirement, modify goals and/or look at risk differently. This leads me to my next discussion point.

Sometimes the allocation decision is “needs based.” Here is a real life example. I have a 60 year old client that claimed to be risk-adverse. She only wanted to invest in fixed income. This was several years ago when you could still count on 3-4% from the bond portfolio. Given specific inputs such as: current asset value, social security payment expectations, annual budget and inflation to name a few variables, this client would theoretically run out of money in her mid-80s because the total return the portfolio provided did not keep pace with her needs. Subsequently, we re-ran the financial plan by adding equities into the allocation mix. Because equities have a higher long-term performance history, the greater the equity exposure in her 40 year plan, the greater the probability of success and meeting her goals. The take-away here is that the longer the investment lens, the less risk there is in investing in growth assets. One’s retirement might be 5 or 10 years away, but the invested portfolio needs to produce income and growth over 30+years.

Reframing risk for our clients is an important role we play. Paradoxically, in the above example, a risk-adverse client wanting to invest in only fixed income was taking on tremendous risk of running out of money and not keeping up with the purchasing power of the dollar. The investible asset value, investment return expectations and cash flow needs can substantially alter what is possible from one client to the next. In the case of the above example, increasing the equity portion in an overall allocation would allow for a more generous cash-flow distribution to subsidize current income needs in retirement.

Over time, the near-term volatility risk of the equity market has been offset by the long-term track record of equities. Every client circumstance is unique and needs to be evaluated. That said, if you know you will be buying a car in the next 3 to 5 years, you want to protect those funds and keep them in short-term, income producing investments. On the other hand, if your granddaughter was just born and you would like to contribute to a 529 plan, she will not be needing those funds for 18-20 years, so you can afford to have a higher concentration of equities in the portfolio. As a final note, the longer your investment time horizon, the less risky it is for you to own growth/equity assets.

When considering your personal financial planning, if this sounds like a discussion you would like to have, we are happy to engage with you. Please reach out to your Telemus Advisor or me at creardon@telemus.com.