What Is Asset Allocation?
Asset allocation and diversification are industry terms used when discussing how an individual’s money is invested. At its core, asset allocation is the mix of stocks, bonds, and cash someone has invested. Diversification other the other hand is the different holdings within the categories of stocks, bonds and cash. The purpose of asset allocation and diversification is the calculated effort to spread out the risk of your holdings while aligning the investments to your tolerance of risk. Or in other words, making sure all of your eggs aren’t in one basket.
What’s The Right Asset Allocation For You?
A Standard Risk Tolerance Questionnaire
If you’ve worked with a financial advisor in the past, you may have filled out a risk tolerance questionnaire.The questionnaires are usually quantitative and qualitative in nature. The quantitative or measurable questions are generally “How long do you plan to have your money invested” and “What’s your time horizon for the money”. Then the qualitative or subjective questions are generally, “Imagine that in the past three months, the overall stock market lost 25% of its value. What would you do?” or there will be a question with a chart like this; “We’ve outlined the most likely best-case and worst-case annual returns of four hypothetical investment plans. Which range of possible outcomes is most acceptable to you? The figures are hypothetical and do not represent the performance of any particular investment.”
You end up answering all of the questions on the questionnaire, tally the points, and you have your risk tolerance. From there, your financial advisor will help align your risk tolerance to the prescribed asset allocation.
An old rule of thumb was to subtract your age from 100. The idea is your asset allocation should change every year based on your age while using a life expectancy of 100. As an example, if you are 30 years old, and you used this rule of thumb, you would allocate 70% of your money to equities (stocks) and 30% of your money to fixed income (bonds). If you are 70, 30% of your money would be in equities and 70% would be in bonds. There are many problems with this rule of thumb, just like most rules of thumb, they aren’t a one size fits all concept. People are living longer, it’s assuming every investor has the same tolerance for risk, investment time horizon, goals, and the list goes on.
The New Wave of Questionnaires
In the last few years, financial planning firms have started using a purely quantitative questionnaire over the standard qualitative/quantitative assessment that’s been around for decades. As an example, at Financial Independence Advisors, we use Riskalyze to understand our client’s appetite for risk. Their unique approach takes subjectivity out of the risk tolerance equation. What we really like, the results take an ambiguous result from the standard risk tolerance questionnaire and put them into concepts anyone can understand, a speed limit sign. Curious to see how it works? Find out here
One of the most important factors of asset allocation is time horizon or the length of time your money will be invested before withdrawing it. The shorter the time horizon, the more conservatively the money should be invested. It’s not uncommon to have accounts with different time horizons and different asset allocation strategies. Using the bucket strategy, you may have short, intermediate and long-term accounts. With each account, you have a different risk profile and ultimately a different mix of stocks, bonds and cash in each.
Common Fears & Pitfalls
Lack of Trust In The Market
Investing can be a bumpy road. Look no further than the end of 2018. From Jan 2nd – Oct 1st the S&P500 was up just shy of 8.5%. From Oct 1st – Dec 27th the S&P500 was down just shy of 15%. In addition, many millennials were at their first job and just started investing during one of the biggest downturns in market history. Millennials have seen some difficult markets in their short adult lives, it’s understandable why they are skeptical.
Holding Too Much In Cash
A little as a year ago, only 1 in 5 millennials said the stock market is the best place to have their money for the next 10 years. In another survey, it was found that millennials keep 65% of their assets in cash. While the last of trust in the stock market is understandable, foregoing potential investment returns in the interest of safety simply won’t deliver the returns needed for the majority of Americans. Regardless of their future goals. The average savings account rate at the time of this writing is .1%. It will take 720 years for the money in the bank to double. That’s before you factor inflation into the picture. With inflation, you’re now looking at a negative real return on your savings.
Target Date Funds
If you are unfamiliar with target-date funds, you pick a date at some point in the future as your time horizon and the asset allocation of the fund is determined by that date. The longer the time horizon the more stock. While this type of investing works for some, the money isn’t invested based on your risk tolerance. Target date funds are more of a “rule of thumb” way to invest your money. Is this the worst thing you could do money? Absolutely not. That said, your money should be invested based on what’s appropriate for you, not what’s appropriate for the masses.
There is no one size fits all when it comes to asset allocation. It shouldn’t be based purely on age, investment size, or time horizon. Instead, it should be specific to you, your goals and your appetite for risk. Talk with a financial advisor to understand how your money is invested, expectations for portfolio returns and come up with a plan of action for the inevitable swings in the market.
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