The Importance of Asset Allocation

Disclaimer: I am not a licensed financial advisor, and the information in this article is not meant to be individualized financial advice. Everyone’s situation is different, so if you are unsure about what to do with your funds, please seek an advisor that can consider your own individual case and make recommendations to you.
When I first began reading about asset allocation for my investment accounts, I felt like I had just opened up Pandora’s Box. You can find endless articles and blog posts on the subject, but I feel that many of these over-complicate the issue.  The truth is, asset allocation can be as simple or as hard as you choose to make it. Mutual funds that are focused on different fund classes are an option, but probably not the best one. The reason for this is the additional fees associated with mutual funds that inevitably eat into your earnings. For this reason, I choose to diversify my portfolio among a variety of low cost index funds. For more on index funds, read this post where I give some background.
Before I get too ahead of myself, let’s talk about why asset allocation is important. Asset allocation allows you to spread your risk out over multiple asset classes in order to decrease the possibility of catastrophic loss in any one class. The major asset classes include: equities (stocks), fixed income (bonds), and cash equivalents. I would also add real estate (REITs) and commodities (Gold, oil, silver, etc.) as separate classes even though they aren’t considered “traditional.” Within each of these large classes it is further broken down into many subsets, then many of those subsets are broken down into further subsets. This could get confusing and complicated if you are trying to micromanage every portion of your portfolio. But what can happen with improper asset allocation? In short, you can lose a lot of money, but this is best illustrated with examples.
First let’s look at an extreme example of what can happen with little or no asset allocation to drive home the importance of diversification. Say you decide that you really like Apple products and choose to invest all of your retirement savings into Apple stock. Now jump forward to the year before you plan to retire. A new cell phone is made that completely blows the iPhone out of the water. Since most of Apple’s profits are from their phones, their stock price plummets, they are no longer profitable, and they go out of business. In this example, you lose most, if not all, of your retirement funds. This is not the most likely scenario, but you never know what the future holds. Where did you go wrong here? You put all of your proverbial eggs in one basket. You were not at all diversified, and that led to significant loss.
Now let’s look at an example that is a little less extreme but that involves only investing in one asset class. In this scenario, you decide to use a low cost S&P 500 index fund, but you have very unfortunate timing. It’s January 2008 and you are very excited that you will be retiring in a year. Between January 2008 and January 2009, the US stock market dropped about 37%, which means that you only have 63% of your initial investments available for retirement when the day comes. Do you think this drop would drastically alter your retirement plans? Most likely. These investment mistakes can be financially devastating and should be avoided at all costs. In the first example, you were very risky with your asset allocation, only investing in one fund (Apple) in one subset of one asset class (US equities). In the second example, you had a little less risk because you were more diversified over the 500 biggest equities in the US (S&P 500 index fund), but still this is only one subset of one asset class.
No matter how well you diversify, you will always have some risk when investing and could always lose money, but proper asset allocation makes that less likely. Also remember that timing can play a huge role in return, so no matter your allocation, investing should be a long term plan.
Individual asset allocation should be a well thought out process with your goals in mind. Based on previous returns and volatility, it is possible to estimate what your returns will be; but, usually, with higher returns comes more risk. It is conventional wisdom that the more money you put into bonds and cash equivalents, the safer and less volatile your portfolio will be. This should be a strong consideration for you, because if you have so much risk in your portfolio that you are losing sleep due to worrying about how the market will perform, you need to make some adjustment. A good financial advisor can be a valuable asset in helping you to make your decisions, but there are a lot of online resources that can help you get started for free. I have recommended this book before, but I feel that it is very fitting in this situation as well: The Bogleheads’ Guide to Investing helped me significantly when I was starting out.  Also lazy index fund portfolios is a very good resource if you choose to go that route.
Initially I decided that I was going to allocate my funds using the three fund portfolio because it was so simple, but later, after much reading and learning, decided that I would like to be exposed to more asset classes including REITs and commodities. My current allocation includes: Domestic stocks (value and growth), international stocks, emerging markets, bonds, precious metals, REITs, and energy. This is what I have chosen based on my goals, but this allocation may not be right for you.
After you choose your allocation and invest your money accordingly, it is inevitable that some classes will grow more quickly than others. This means that “rebalancing” will need to occur at regular intervals to keep you on track with your target asset allocation. Basically this means moving your money around to achieve your target percentages once again. Usually once a year is sufficient for this, but some choose to rebalance more often.
How do you plan to allocate your assets? Are you comfortable with a lot of risk in your portfolio or are you more conservative? I hope that this information will help to get you started if you haven’t already. Thanks for reading!

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