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 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. As we show in our research report, Four Steps to a Better Retirement, 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
So how does this impact your portfolio?
As you think about designing your own portfolio, we return to the initial point: asset allocation trumps market timing and security selection. More academic research reaffirms that point: a 2010 study by Fama and French showed that after deducting costs, actively managed equity funds actually underperformed their benchmarks by between 0.81 percent and 1 percent annually from 1984-2006. A full review of literature and academic in 2011 research concluded that “it is extremely 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 portfolio and 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 to come up with a balanced solution.
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:
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:
Determine your risk level by considering the following:
- Risk tolerance (comfort with market fluctuations)
- 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. 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.
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? Call us at 855-855-8005 and a Personal Capital Associate will help assist you with your questions.