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Asset Allocation is a critical topic in investing. Your asset allocation will define the mix of asset classes in your investment portfolio. For most people, this is simply the question of how much stocks, bonds, and cash they need in their portfolio.
Your asset allocation will determine your expected returns and your expected volatility. If you are willing to take on a lot of risks (volatility), you can expect higher returns. These returns will protect you against inflation and grow your portfolio over time.
But it is important to choose an asset allocation that suits you. If you take on too much risks and panic sell at the first downturn, you would have been much better with an asset allocation with lower volatility.
In this article, we are going to look in detail at what is the asset allocation and a few things you can consider when you are choosing your asset allocation.
Your asset allocation is how much of your portfolio you are allocating to different asset classes. There are many asset classes, but for this article, we are going to focus on the main three assets classes:
For instance, one could have an asset allocation of 5% cash, 20% bonds, and 75% stocks. Or one could have an asset allocation of 100% stocks. These are valid asset allocation examples.
Generally speaking, different asset allocations have different amounts of risks (volatility).
Now, choosing your asset allocation is critical because it will have to match with your current situation. If you can withstand larger volatility, you can handle a larger allocation to stocks. But not everybody is the same, and even for one person, the situation may change over the years.
It is important to realize the differences between the three main asset classes when talking about asset allocation.
By cash, I do not mean hard cash that you have a home or in your wallet. I mean cash that you have in a bank account. It could also be in a money-market fund, but this will make it less accessible. Of course, if you have a substantial amount of cash at home, you should count it as well.
Cash is the safest of the asset classes. If you leave some cash untouched for 20 years in an account, you know that you will still have the same amount in the end (unless you have fees for your bank account!).
So, cash is the best solution when you need to spend some money because it is ready at hand and is not volatile.
The issue with cash is that its returns are almost non-existent. So, it will not keep up with inflation. So, if you keep your cash untouched for 20 years, it will keep the same value, but its purchasing power will be much lower. Inflation is the main reason why people should invest and not keep everything in cash.
The reason to add some cash to a portfolio is to increase the accessibility of the money.
Bonds are loans by governments or companies. You loan them some money, and in return, they give you back some interest during the loan duration. In the end, they will return your money.
Bonds have significantly greater returns than cash. And they are significantly less volatile than stocks. So, they are the middle ground of investing.
Keep in mind that not all bonds are equal. Some bonds have a higher yield (junk bonds) and much higher volatility. As such, they have no advantages compared to stocks. So, only safe bonds like treasury bonds should be used to reduce the risks of your portfolio.
The problem with bonds is that their returns are not high enough to sustain a lifestyle if you plan to withdraw from your portfolio. If you plan to retire only on bonds, you will need to accumulate a substantial amount of money compared to having stocks.
So, the reason to add bonds to a portfolio is to reduce the volatility.
Finally, stocks are shares of publicly traded companies. You buy a part of the company, and this share can grow in value over time. And in some cases, you can also receive some dividends.
Stocks can generate significantly higher returns than bonds. But they bring in significantly higher volatility as well.
The reason to add stocks is to increase returns. Y0u want your money to grow over time.
A note about Negative-Yielding Bonds
One thing that many people ask is what they should do with their bond allocation when bonds are negative-yielding. It means that people buying bonds are actually losing money over time.
In Europe and Switzerland, bonds have had a negative interest rate for several years now. And it is probably not about to change. In the U.S., bonds are still yielding a positive interest rate, but it is very low.
So, what if you do not want to go 100% in stocks but do not want to invest in negative-yielding bonds?
Since cash has higher returns than negative-yielding bonds (at least for the time being), it makes sense to increase your cash allocation instead of increasing your bond allocation.
Now, cash will have low returns, below inflation. So, if you do not have access to good bonds, you may want to have a higher allocation to stocks and a lower allocation to cash than if you had access to good bonds.
How much stocks and bonds you will choose for your asset allocation will depend on your capacity to take risks.
Your risk capacity will depend on several factors. The first factor is personal. Some people are willing to take more risks than other people. Some people would never have 100% in stocks because they would not be able to weather it.
If you sell everything when your portfolio is down 10%, your risk capacity is quite low. On the other hand, if you are not going to panic when your portfolio is down more than 50%, you have a great risk capacity. Now, it is pretty much impossible to know your risk capacity without experiencing it. Many people think that they would not panic, but in practice, it is sometimes different.
Another way to approach your risk capacity is based on your current financial situation. If you are currently still working (at a stable job) and are heavily investing to accumulate a large net worth, the chances are that you can take on a lot of risks.
On the other hand, if you are already retired without income and live from your investments, it may be more dangerous to take on a lot of risks. Indeed, if you have to sell during a large downturn, you may make your situation more difficult. This risk is called a sequence of returns risk.
Finally, your asset allocation will also depend on your goals. If you are willing to retire early with your portfolio, you will need a large allocation to stocks if you want your portfolio to last a long time. If you plan to retire at 60, you probably do not have to plan for more than 40 years of retirement.
But if you plan to retire at 40 (or even earlier), you are looking at a very long retirement. And to sustain a very long retirement, you need an asset allocation with a substantial allocation to stocks.
So, there are many things to take into account when you decide on your asset allocation.
Rules of thumb
Over the years, there have been a few rules of thumb to choose your asset allocation easily.
The most well-known rule is to hold your age in bonds and the rest (100 minus your age) in stocks. For instance, if you are 40 years old, you will hold 60% in stocks and 40% in bonds. The problem with this rule of thumb is that it is really too conservative for most people. For me, at 32 years old, in the accumulation phase, 32% of bonds do not make sense. Also, life expectancy has changed since the introduction of this rule. So, the rule needs to be revisited.
A more recent rule of thumb is to hold 120 minus your age in stocks. If you are 40 years old, you will hold 20% in bonds and 80% in stocks. And at 60, you will be at 40% bonds and 60% stocks. For me, it would give 88% in stocks currently. It already makes more sense. But this is still a rule of thumb.
Even though rules of thumb can help you give an idea of what people do, your asset allocation depends on too many parameters to rely on a single rule of thumb. As we saw in the previous sections, you need to take into account your risk capacity, your current situation, and your goals.
The bigger picture
There is one thing many people forget when they consider their asset allocation is to consider the big picture.
When you think about your asset allocation, you should not only think about your broker account assets. You should also think about your retirement assets. The bigger picture is fundamental to consider.
For instance, if you have a large second pillar, you probably do not need bonds in your third pillar and your investment portfolio. And on the contrary, if your 10% of bonds in your investment portfolio but all the rest is in stocks, you may not have the asset allocation.
Your asset allocation should always apply to your entire net worth, not to a portion of it.
Your asset allocation is not fixed
I mentioned before that your current situation is important when considering your asset allocation.
Since your current situation will change over time, so may your asset allocation. For instance, I mentioned before that your asset allocation during the accumulation phase might not be the same as the asset allocation during the asset preservation phase.
Or, if you lose your job (or quit your job for some time), you may want to have a few more bonds to help you cope in case of a downturn.
So, when your situation changes, you may want to review your asset allocation accordingly. In general, you should probably review it once a year.
Some people mix up asset allocation and diversification into each of the asset classes. I prefer to keep these two concepts separated.
Once you have chosen your asset allocation, diversification is crucial. Within each of your asset classes (except cash), you should diversify. This will greatly reduce the volatility in your portfolio.
So, if you have 60% of stocks, you still need to diversify these stocks. For these, index funds are great because they let you invest in thousands of stocks with a single fund. And index funds also let you diversify globally by investing in each country of the world.
And you should also diversify your bonds with many bonds. But you probably should not diversify your bonds globally if you do not want to lose the volatility reduction advantage of bonds.
With this guide, you should be able to start setting your asset allocation. To do it well is more important than people think. And it is also more difficult to set than some people may make it look like.
Most of the rules of thumb are outdated and too simplistic to set your asset allocation. Your asset allocation is too much of a personal thing for a simple rule of thumb to help.