Investing success is as much about having the right process as it is about choosing the right investments. Avoid the barrage of money messages by focusing on one simple question: What is the most important factor affecting your investment return? The answer is: A proper asset allocation strategy based on a balance of your risk tolerance and need for growth.
An oft-quoted study, Determinants of Portfolio Performance, showed that over 90 percent of a portfolio’s return variability is due to asset allocation – more than market timing and security selection. While there’s disagreement among academics over exactly how much impact asset allocation has on performance, in practice it’s the first order of business for institutions with a lot of money to manage.
For instance, check out the annual report or update of a typical university endowment (see here for the Stanford University Endowment’s). You’ll likely notice that the first component of the investing strategy addressed is asset allocation.
Moving to an asset allocation-based passive investment strategy may optimize your own portfolio, and make the difference between retiring on a shoestring budget or a lifestyle of champagne dreams and caviar wishes.
What is Asset Allocation?
To help visualize what asset allocation actually means, it’s helpful to use an analogy. We use a soccer team. To build a great soccer team, you need defensive and offensive positions. Having strong players in both areas is critical to accomplishing the team’s objective – to win.
In investing, the offensive and defensive players are like asset classes. Asset classes are types of investments that exhibit similar levels of risk and return, such as equities, fixed income, and real assets. As on a soccer team, you need a variety of asset classes: some that are offensive – which do well when the economy is charging ahead – and are defensive – that do well when the economy is falling behind.
Mixing asset classes is important because asset classes have shown different behavior in different market conditions. In investing speak, they’re not correlated. In practice, investors look at an asset class “correlation matrix” to help determine the optimal amount to balance in a portfolio. Balancing asset classes helps to decrease portfolio risk without losing returns. A portfolio’s asset allocation that minimizes risk while maximizing returns is called “efficient.”
The Impact on Your Portfolio
As you think about designing your own portfolio, we return to the initial point: asset allocation trumps stock market timing and security selection. A 2016 report by Standard & Poor’s shows that less than 8% of all large-cap, mid-cap, and small-cap equity funds outperform their benchmarks over a 15-year period. When you look more broadly at all domestic funds, 82% underperform over that 15-year timeframe. Based on these numbers, it is very difficult for an actively managed fund to achieve persistent outperformance in the medium to long term.
In other words, tracking the markets has proven to be better, on average, than picking stocks or trusting managers to pick stocks for you. Furthermore, the fees associated with active investing can significantly drag down performance, thereby extending the years you are required to work.
If you decide to design your portfolio with passive investments, the great news is that it reduces your workload in that it requires few changes after the initial investment selections. However, designing a proper allocation and sticking with it can be more difficult than it seems. An incorrectly allocated or not properly diversified portfolio or investing strategy can be an expensive mistake.
For instance, choosing overly-conservative investments may result in lower than necessary returns, a smaller retirement fund and less money to live on retirement. A too-aggressive portfolio exposes an investor to unwanted risk, and may result in lost capital if withdrawals are required when the market is low. The key is to do an honest self-assessment of your risk tolerance and your desired realistic investment returns and financial goals to come up with a balanced solution and a good asset mix.
Let’s look at a couple of appropriate allocations. Let’s say you’re 30 years old and plan to retire when you’re 65. You can likely afford to take a good level risk and put a big chunk of your money in equities. Here’s what an allocation might look like for you:
An aggressive growth allocation for those with a long time horizon and who are willing to take a high degree of risk in pursuit of higher returns:
|ASSET CLASS||ASSET ALLOCATION|
|Domestic Fixed Income||2.2%|
|Foreign Fixed Income||0.8%|
Let’s say you’re 55 years old and don’t plan to retire until you’re 70. You’ve got some other expected income streams, like social security and your firm’s pension fund, so you can still take risk in your portfolio. Depending on your other finances, you should not likely take the same level of risk as the 30-year-old. Here’s what an allocation might look like for you:
A long-term growth allocation with moderately lower volatility than an all stock portfolio. This allocation is often suggested for those who are several years from retirement or who need or want high growth in retirement.
|ASSET CLASS||ASSET ALLOCATION|
|Domestic Fixed Income||10.6%|
|Foreign Fixed Income||2.4%|
What is Your Level of Risk Tolerance?
You can begin to determine your risk level by considering the following:
- Risk tolerance (comfort with market fluctuations)
- Take our risk tolerance assessment to see where you might fall: do you lean towards aggressive, moderate, or conservative?
- Time horizon (how long until you will need to withdraw funds)
- Your investment knowledge
- Total assets
Simplify this process and get a customized asset allocation recommendation with Personal Capital’s Investment Checkup tool.
Want to Dig Deeper into Your Portfolio?
As the single most important ingredient in long term investment returns, it is critical to understand the asset allocation of your entire investment portfolio. How heavily should you be investing in mutual funds? How about index funds? What about alternative investments like real estate? Yet accurately identifying it can be challenging and time-consuming.
We can help. Monitor your investments easily and securely with Personal Capital’s award winning free service, which provides a valuable overview of all of your investment accounts. Personal Capital’s new proprietary Investment Checkup analyzes your portfolio(s) to help make sure you’ve got the proper asset allocation that suit your overall investment objectives.
In addition to analyzing your portfolio(s), Personal Capital can also help track your income, spending, assets and liabilities, and provide additional customized investment assistance. To grow your finances it’s important to first have a good grasp of your overall financial picture.
Still have questions or want to learn more? Contact a financial advisor.
*Editors Note: This post was originally published in January 2014 and has been updated for accuracy and comprehensiveness.