Learn what asset allocation is, why it’s an important part of any investor’s investment strategy, and the different rules of thumb investors follow to create a strategic asset allocation plan.
In this article:
- Asset Allocation Defined
- Investment Horizon
- Risk Tolerance
- Understanding the Risk-Return Tradeoff
- 5 Asset Allocation Rules of Thumb
- Why Asset Allocation Is Important
- Asset Allocation Models Aren’t Perfect
Rules of Thumb to Guide Investors in Creating a Strategic Asset Allocation Plan
Asset Allocation Defined
Asset allocation is the practice of splitting up one’s investment portfolio into different assets like cash, bonds, and stocks.
Choosing the kinds and volumes of assets to include in one’s investment portfolio can be a very personal process. This is because personal factors, like investment horizon and risk tolerance, determine which asset allocation strategy can best work for investors.
An investor’s investment horizon is the expected length of time an investment will be maintained to achieve a financial goal. Investment horizon may significantly influence an investor’s risk tolerance levels.
A longer investment horizon can help investors feel more comfortable with making higher-risk investments. This is because investors can afford to wait until things get better during bear markets.
On the other hand, a shorter investment horizon may make investors feel more comfortable taking on lower-risk investments. This is because investors don’t have the luxury of waiting for a bear market to reverse to a bull market.
Bear Market Definition: This occurs when prices of assets in financial markets, (i.e., stocks), are falling and are expected to continue doing so.
Bull Market Definition: When asset prices in financial markets, i.e., stocks, are going up and are expected to continue doing so.
This refers to an investor’s willingness and ability to lose part or all of their initial investment. Such willingness and ability are determined by an investor’s desire to earn potentially higher returns (i.e., the risk-return principle).
What is the Risk-Return Principle? The higher the expected return on an investment is, the higher the financial risk and vice-versa.
Investors who can tolerate high levels of investment risk can be classified as aggressive investors. They are more likely to take on higher investment risks for an opportunity to get superior investment returns.
On the other hand, more conservative investors have a lower risk tolerance. This means they are more inclined towards investments that can preserve their capital rather than obtaining superior returns.
Understanding the Risk-Return Tradeoff
Investors have an understanding that there’s no such thing as a risk-free investment. All investments have complexities and the only thing left to discuss is the degree of risk each investment has.
However, with these complexities also comes the opportunity to grow one’s capital. Because of inflation, keeping cash also exposes people to the risk of loss, (i.e., lower purchasing power).
Inflation Definition: The rate at which prices of basic goods and services increase every year.
Keeping cash may preserve the amount but because of the increasing prices of goods and services, the number or volume of things it can buy in the future will decline.
Now, the question is, how will investors of different risk tolerances most likely allocate their investments?
- Long-Term Investors — Investors with long-term financial goals (longer investment horizon) will most likely allocate more investments in complex assets, like stocks.
- Medium-Term Investors — Those with medium-term financial goals may allocate more of their investments in mid-risk assets like bonds and commercial papers.
- Short-Term Investors — Investors who have short-term financial goals, (i.e., short investment horizons), will most likely use a conservative asset allocation strategy. This means the appropriate allocation strategy would be investing most, if not all, of their funds in cash or near-cash investments like time deposits and closely-maturing high-quality debt instruments like U.S. Treasuries or investment grade commercial bonds.
5 Asset Allocation Rules of Thumb
1. 100 Minus Age
Many consider subtracting one’s age from 100 as the pioneering investment allocation principle. In particular, the difference will determine how much of one’s portfolio will be allocated to stocks or stock-related assets.
- A 30-year old investor will get a difference of 70 after subtracting the age from 100.
- Using this allocation strategy, this investor will invest 70% of his investible funds in stocks.
This strategy attracts many investors because it’s simple and easier to implement.
2. 120 Minus Age
The second way investors base their portfolio allocation, particularly in stocks, is subtracting one’s age from 120. As with the first age-based allocation strategy, the difference tells investors how much of one’s funds should be invested in stocks.
- The same 30-year old investor will yield a difference of 90, from 120 minus 30 equals 90.
- This means that this investor will allocate 90% of his investible funds in stocks.
3. An “Inner Peace” Based Asset Allocation Model
Bestselling investment guru and author Burton Malkiel first broached the idea of this kind of stock investment allocation strategy. In his classic investment book A Random Walk Down Wall Street, he suggested maintaining a level of risky investments that allows one to sleep peacefully at night.
This strategy doesn’t require number crunching to figure out how much to allocate. Investors simply check in with their gut and see if they can sleep soundly at night.
This may seem like an un-objective way to invest, which it is. However, many investors opt for this because it allows them to balance returns with their risk appetites while keeping sane.
4. Fixed Asset Allocations
Many investors also go for simpler asset allocation models like fixed asset allocations.
While fixed allocations can require some work to determine, it’s probably the simplest asset allocation method. It’s simple because after investors fix their allocations, they can just leave their investments to do their thing.
Investors only have to decide how much of their portfolios will be allocated to certain assets. These may include stocks, bonds, cash, or mutual funds, among others (i.e., 50% stocks, 40% bonds, and 10% cash).
Once investors set their allocation percentages, they can simply keep it for life. They need not adjust proportions as they age or according to market developments.
The underlying principle of this method is that there’s no need for investment allocations to change much throughout an investor’s life. This is because even at retirement, investors still need to continue growing their funds for potentially longer retirement years.
5. Allocating Within Specific Asset Types
Another way to allocate assets is by allocating within specific asset types. After all, even assets of the same type behave differently under specific market and economic conditions.
For example, stock investments can—and should be—allocated across several stocks of companies from different industries. By doing so, a downturn in one industry, say the retail industry, will not affect the entire stock investment portfolio.
Allocating within specific asset types can also help investors achieve better returns. This is because some may respond more positively than others under the same economic or market conditions.
Why Asset Allocation Is Important
Asset allocation is at the heart and soul of portfolio diversification. When investors are able to wisely allocate investments across different assets, they can optimize returns according to their risk tolerance.
Investors who allocate investments across assets that move differently under varying market conditions can minimize potential losses and optimize returns. When one type of investment reacts negatively to a particular market event or condition, others in the portfolio may be able to make up for such reactions by reacting differently to the same market development or condition.
Asset Allocation Models Aren’t Perfect
While asset allocation models can help investors achieve optimal results based on their personal preferences, they’re not perfect. They also have their limitations and concerns.
Concerns for Age-Based Asset Allocation Models
The age-based asset allocation models don’t tell investors where to invest the remaining funds (i.e., non-stock funds). Investors will have to figure it out on their own.
Another issue some investors have with the age-based allocation models is average lifespan. Unlike in the past when the models were first used, people today live much longer.
When investors expect to live longer, they need to invest more of their funds in more complex assets, like stocks. This is to optimize the chances of their funds growing enough so they can fund their extended retirement years.
Concerns for Fixed Allocation Models
Fixed allocation strategies also have their own set of concerns. The most glaring of which is the fact that while the allocation may be fixed, market conditions change over time.
This means that while a specific allocation may work well under current market conditions, it may no longer be optimal when conditions change in the future.
But still, using asset allocation models can still prove to be very beneficial to investors over the long haul. This is because they can provide some semblance of order and logic to one’s investing efforts.
Failing to plan is planning to fail, and using asset allocation models can help investors plan their investment strategies well. When they’re able to do that, they can optimize their chances of achieving their financial goals through successful investing.
What does your investment portfolio look like? Is it allocated across different types of assets or is it concentrated on just one type? We’d love to hear from you so let us know in the comments section below.
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