A Primer on Asset Allocation
The first tenet of Invariant’s investment philosophy is “The primary determinants of investment success are appropriate asset allocation and client behavior.” We have written blog posts about client behavior – but what about asset allocation?
What Is Asset Allocation?
Asset allocation refers to the practice of dividing an investment portfolio into different categories of assets – primarily stocks, bonds, cash, and alternatives. These asset classes have different levels of expected risk and return, so each will perform differently over time.
Investing in different asset classes can improve risk-adjusted returns via diversification. Nobel Prize laureate Harry Markowitz is quoted saying, “Diversification is the only free lunch in investing.” Diversification is achieved by building a portfolio invested in multiple uncorrelated or inversely correlated (meaning they do not always move in unison) assets that perform differently under various economic conditions. Economic conditions that lead to strong performance in one asset class often are the same conditions that lead to poor returns in another asset class. As a result, you will reduce the risk that portfolio components are simultaneously performing poorly, smoothing long term returns.
An investor’s asset allocation is dependent on several factors, such as their time horizon and risk tolerance, and may change over time as circumstances shift.
Characteristics of Major Asset Classes
Stocks have historically had the greatest risk (volatility and drawdowns) and highest returns among the three major asset categories. On average, those with a longer time horizon and a higher risk tolerance should have a higher allocation to stocks.
Bonds are generally less volatile than stocks but offer lower expected returns than stocks – especially in today’s low interest rate environment. At times, they are uncorrelated or even inversely correlated with stocks, potentially providing a cushion when stocks are in a drawdown. As a result, investors with shorter time horizons and lower risk tolerance may have a higher allocation to bonds.
Cash offers the lowest return and lowest risk major asset categories. The federal government often guarantees investments in cash and cash equivalents. The primary risk of holding cash is that it will lose value via inflation.
Alternatives can be thought of as “everything else” and include but are not limited to real estate and commodities. This risk, return, and correlation characteristics vary greatly depending on the asset – especially when considering investment vehicles like hedge funds.
Factors Affecting Your Asset Allocation Decision
If your portfolio needs to generate a certain rate of return, you will need to take adequate risk to have the best possible chance of achieving that rate of return. On the other hand, if the necessary rate of return is lower, the investor may not need to take as much risk with their asset allocation.
Risk tolerance refers to the volatility and drawdown profile deemed appropriate by an investor. Both willingness and ability to take risk matter.
An investor with a longer time horizon will be able to take more risk with their asset allocation as returns are more predictable in the long run than the short run.
Volatility can hurt portfolios with liquidity needs because there is a risk that you may need to sell investments to generate the liquidity at an inopportune time. All else equal, the greater the liquidity needs relative to the size of the portfolio, the less risk an investor should take with their asset allocation.
Asset allocation is a vitally important part of investing and financial planning. Your financial advisor can help you determine which asset allocation reflects your unique financial scenario. Working together, you can craft an investment strategy for every phase of your life, ensuring that your strategy keeps pace with your changing goals.