What is Asset Allocation? – Smart, Simple Investing
When it comes to investing, it’s easy to get lost in all the different options and the ups and downs of the market, so let’s keep it simple. I like simple, especially when simple is so effective.
In this blog, we’re going to talk about the simple and effective way to invest your money with proper asset allocation.
If you read my previous post about Independent Retirement Accounts (IRAs), I hope it convinced you to open an IRA! If you did, first of all, right on! But you may be wondering “Now what?”.
Here’s the next step.
What is Asset Allocation?
Let’s start from square one. There are a lot of different assets available to put your money in:
- Real Estate
- Private Equities
- Commodities and Natural Resources
It may be a bit to obvious to say, but asset allocation is allocating the money in your portfolio between these different classes of assets.
I mean, sure. You could go all in on Tesla (TSLA). Or even “YOLO” your life savings on the next r/wallstreetbets short squeeze. However, it is generally recommended that your investments are diversified and appropriate for your goals, timeline, and risk tolerance. Asset allocation is an effective and EASY way to do this.
As defined above, asset allocation is apportioning, or allocating, your portfolio into different asset classes based on your goals, timeline, and risk tolerance. For example:
- If you have a longer time frame and/or you don’t mind taking risks, you will have a more aggressive asset allocation.
- If you have a shorter timeline and/or want to avoid risk, you will have a more conservative asset allocation.
Here are some examples from Investopedia:
Equities are stocks, which are typically a more volatile and risky asset than fixed income securities (things like bonds) or cash. On the flip side, stocks usually provide higher returns. Higher risk, higher potential return. You can see why the more aggressive portfolio would have a higher percentage of stocks.
Bonds are sometimes referred to as “fixed income securities” because they provide a fixed return over a fixed timeline. Their fixed return obviously makes them less volatile and risky, and therefore a conservative asset allocation will have a higher percentage dedicated to bonds.
It is usually good to have a little cash in your portfolio to help keep your asset allocation on target as the market value of other assets fluctuates. It also gives a bit of room to make withdrawals without having to immediately liquidate a position.
Setting Up Asset Allocation in Your Portfolio
So how do you manage and set up your own asset allocation?
There are several ways to do this.
In order from least convenient to most convenient, you can:
- Select individual securities and manually adjust your asset allocation as needed
- Invest in index funds and still manually adjust your asset allocation
- Invest in funds with a pre-configured asset allocation
- Use a robo-advisor to do it all for you
1.) Selecting Individual Securities
If you prefer, you can choose your own individual stocks, bonds, and other securities and manually invest in these in the amounts that match your desired asset allocation.
For example, if you wanted to invest $10,000 with a 60/30/10 asset allocation…
- That’s 60%, or $6,000, in stocks
- 30% ($3,000) in fixed-income securities
- 10% ($1,000) left in cash
You could purchase a variety of different stocks to put together that $6,000 in equities, and you could purchase a variety of different bonds or notes for that $3,000 in fixed-income securities.
This works well enough, but as the market fluctuates you will need to make adjustments manually to stay on track. Say stocks had a killer year, but bonds remained mostly flat. You might then have $7,000/$3,000/$1,000 in equities/fixed income/cash. You would then have to sell some of the equities to buy more bonds and leave a little extra in cash.
If you’re selecting individual securities, it can become increasingly tricky to decide which ones to liquidate and which ones to purchase more of. You can simplify that with index funds.
2.) Asset Allocation with Index Funds
Index funds will allow you to invest in market segments or asset classes as a whole, so you could manage the asset allocation of your whole portfolio with just a handful of index funds. (Here is some extra information to get started manually investing in index funds.)
This is still a manual approach, but considerably easier than selecting individual securities. It could be as simple as selecting one index fund for equities,and one index fund for fixed income securities.
3.) Pre-configured Asset Allocation
If you’re looking for something even easier still then there are funds you can invest in that will follow or be set at a particular asset allocation. One example is Target-Date Funds. These are funds that have a set time horizon and level of risk, and their asset allocation will be adjusted accordingly as time goes on. These are very commonly found in retirement portfolios, such as 401(k) accounts or IRAs.
Last, but not least, you can just let computers do the work for you with a robo-advisor. A robo-advisor will usually ask you a few questions to determine your goals, timeline, and risk tolerance. It will then set up an asset allocation based on your responses. The robo-advisor will automatically keep track of your account and adjust your holdings as changes in the market may affect your desired asset allocation. This is the easiest way to manage your investments, but you also have less control.
A lot of different banks and investment firms offer robo-advisors nowadays, so a quick search will bring you plenty of options.
If you have any questions about asset allocation, let me know in the comments below!