Asset Allocation: What It Is and Why It Is Important

If you want to build an investment portfolio, what’s the first thing come up in your mind? Is it what particular stocks/mutual funds/ETFs you want to buy? Or is it a blueprint of how you want to invest your money? My answer to this question is: I want to have a clear plan on how I want to invest before getting into the details of exactly what I want to buy. And the answer to “how I want to invest” is asset allocation.

So What’s Asset Allocation?

Before talking about how to allocate different asset classes in a portfolio, we should first know what exactly is asset allocation. As Investopedia puts it, asset allocation is

an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.

So basically, asset allocation is a method to mix different asset classes (such as equities, fixed income, and cash) in the portfolio in order to achieve the maximum long-term return of the investments while reducing the risk to the minimum. As the above definition indicates, an asset allocation plan is not something that you come up randomly. Instead, to achieve your goal, you will need to create a plan based on your investment goal (what you want to achieve), your risk tolerance level (how much risk you can take), and your time horizon (when you want to use the money). Since all these three factors change over time, the asset allocation plan also evolves.

Why Is Asset Allocation Important?

Now we know what asset allocation is, let’s take a look why it’s important in achieving your long-term investment goal. Following is a chart that I drew based on the Efficient Frontier theory. As we all know, in order to receive higher return, higher risk must be taken. For all the asset classes, equities historically provide investors with the highest returns over the long-term, but stocks also incur the highest risk (think about the stock markets now). What Efficient Frontier theory argues is that an investment portfolio can be optimized, as long as all asset classes are included and properly weighted

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In the above picture, the red line is the efficient frontier curve, which represents the optimal return-risk relationship. That is, points on the curve represents portfolios whose returns are optimized for their corresponding risk levels. Portfolios below the curve are taking unnecessary high risk but getting poor returns (high risk, low return), while portfolio above the curve are impossible to achieve at the corresponding risk levels (high return, low risk). Another interesting observation from the above curve is that by properly allocating different asset classes (a point on the curve), you can expect a higher return without taking extra risk. This’s why asset allocation is important.

How to Choose the Right Asset Allocation?

OK, here comes the most difficult part. Why it is difficult? Because, unlike the above concepts, there is no clear answer on how much you should invest in each asset asset class. It’s a personal decision that largely depends on your own investment goal, time frame, and risk tolerance level. But there are some general guidelines you can follow. For instance, if you are young and have some 20, 30 years to retirement (assuming that your investment goal is for a comfortable retirement), then you can afford to put a large portion of your investments in risky assets such as stocks because you will still have enough time to wait for the stock market to recover even if it crashes today (like exactly what’s happening today). On the other hand, if you are near or already in retirement, or if you just want to invest for a short-term goal (such as buy a house in 5 years), then you may want to be conservative with your money by  because, given the situation on the Wall Street today, nobody can tell you how soon your investments can return to the level prior to the crash (the level we saw last October). To give you an idea on age-based asset allocation plans, here are some examples from T. Rowe Price that I received a couple of days ago:

• Age 26 – 30, Retirement 2045: Stocks: 92.5%, Bonds: 7.5%;
• Age 31 – 35, Retirement 2040: Stocks: 92.5%, Bonds: 7.5%;
• Age 36 – 40, Retirement 2035: Stocks: 92.5%, Bonds: 7.5%;
• Age 41 – 45, Retirement 2030: Stocks: 89.5%, Bonds: 10.5%;
• Age 46 – 50, Retirement 2025: Stocks: 84.5%, Bonds: 15.5%;

As you can see all the above allocations put 85% or more in stocks because there are at least 17 years to retirement (the age 46 – 50 group), which is a quite long time horizon. Another way to help you determine the right asset allocation for your own investment is taking a look at how the lifecycle funds, or target-date funds, invest their money based on a targeted retirement year. The managers of lifecycle funds are responsible to adjust the fund’s asset allocation as the fund moves close to the target date. By looking at asset allocations at different funds that have a similar time frame as yours, you can have an idea on making up your own plan. I have discussed this topic a while ago when I looked at lifecycle funds from Vanguard, Fidelity, and T. Rowe Price. In addition, you can also find other related discussions on asset allocations:

• Model Portfolios Built with ETFs (IV) – The Intelligent Asset Allocator
• Creating a Virtual All-EFT Portfolio
• Determining the Mix of Stocks and Bonds in Your Portfolio
• There are Lifecycle Funds. Then There are Lifecycle ETFs

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