Why is Asset Allocation so important?

By: Tom Betros, CFA, CFP®

Investors are imperfect beings who tend to make emotional decisions. There are several examples of emotional decision-making in investing, such as buying into market trends, investing based on past experiences, maintaining large percentages of wealth in employer stock, and holding all conservative investments. Emotional investing can lead to success, but more often than not it hinders progress towards financial goals.

Most investors require a certain level of income to support their retirement, lifestyle choices, charitability, or other financial goals. To sustain this level of income, there needs to be accumulated assets to drawdown from. If an investment strategy does not align with an investor's spending needs or risk tolerance, as it typically does with emotional investing, there is a risk of either not saving enough due to low returns or experiencing more severe portfolio declines than can be afforded. Let's look at an example of an overly conservative investor.

This investor has $600k saved and plans on retiring in 5 years. They expect to live an additional 25 years in retirement. If they plan on needing $50k each year in addition to Social Security throughout retirement (inflation-adjusted), they will need approximately $1 million at retirement assuming a 5% rate of return and 3% inflation. If that same investor has all their assets in cash or money market funds today, they will need a compound annual growth rate of approximately 10.7% to reach $1 million. If we assume that money market funds will average about 4% over the next 5 years, that brings the $600k to $730k, a $270k shortfall. Using the same return and inflation assumptions, this investor would only be able to spend about $36k per year. The point being that a strategy that is too conservative can impact your ability to spend, in this case reducing the amount you can withdraw by $14k per year.

What is Asset Allocation?

Asset Allocation is a concept that attempts to neutralize these behavioral and cognitive biases. Importantly, it helps to neutralize biases of the investor AND the advisor because it enforces discipline on the investment process. So how can one begin to think about asset allocation? Before starting to develop an investment strategy, an investor should reflect on their goals and objectives, the capital needed to fund them, how they feel about taking risks (making money or losing money), and when they plan on using their money. These factors will help to determine what asset classes and in what proportions they should be invested in.

What asset classes can you invest in?

There are broad asset classes such as:

·       Equity

·       Fixed Income

·       Cash

And within each asset class there are sub-asset classes such as:

-            Domestic Equities

-            International Equities

-            Domestic Bonds

-            International Bonds

-            High Yield Bonds

These can be broken down even further but for the sake of this article I will stop here. The point is there are lots of different assets you can invest in and knowing the role each play will help build an investment program that aligns to your needs. For example, equities are known to provide capital appreciation over the long-term. Fixed income is known to provide predictable income. International equities are historically riskier than US equities, but they do not perform in lockstep, which has diversification benefits. Long-term bonds are more sensitive to interest rate risk but can provide a partial hedge against a market collapse. So how should these assets be combined? Short answer, it depends on the investor.

Most aspects of asset allocation ARE investor specific, however, there is one thing that is universal. Implementation. Once an asset allocation has been selected and invested in, the only thing an investor needs to do is rebalance the portfolio when it drifts from its target. How can an asset allocation drift from its target? As we discussed earlier, every asset is different which means one asset can outperform the other, which can result in a portfolio imbalance. Let’s say, for example, total equity moved from the target of 60% to 63% and fixed income moved from the target of 40% to 37%. To bring the portfolio back to the desired target allocation and risk level, it would be “rebalanced” back to 60% equity and 40% fixed income. When an outperforming asset is sold (as in this example), the proceeds are used to buy the underperforming assets. The concept of rebalancing follows the basic principle of investing, “buy low, sell high.”

So why is asset allocation so important?

Asset Allocation is important for three reasons:

• It enforces discipline in the investment process which means there are less emotions involved in decision making. Less emotions means the portfolio is “buying low and selling high” NOT “buying high and selling low.”

• Asset Allocation can reduce the variability of financial outcomes which can be critically important to making your money last.

• With regular rebalancing, an investor can be confident the asset allocation strategy will always fit his/her risk profile which will better align the investor’s experience with their expectations.