Investing: Asset Allocation
You have decided to take the plunge and start investing. You’ve gotten over your fears about investing, realizing that if you want your money to grow, you’re going to have to take on some extra risk and invest your money. You’ve learned about stock market history and learned that it’s inherently volatile (so don’t be shocked when it goes through bear markets and recessions- it’s been doing that sort of thing for decades), but it has produced a positive return over the long run. You’ve also determined your investment style; if you’re like me, you like the idea of passive investing through low cost index funds over active investing.
So what’s next? Do you start with one index fund? Or do you buy several? And aren’t you supposed to be buying bonds at some point because you seem to recall that it’s a good idea to do so? What about other forms of investing, like real estate?
This is where you need to understand the idea of asset allocation. You will want to have a mix of asset classes, because sticking with just one asset class is riskier than spreading your investments over a mix of asset classes.
Here are examples of asset classes that make up a portfolio:
1. Equities (stocks): This is the part of your portfolio that’s going to drive your returns. Of course, there’s no such thing as a free lunch. You are taking on extra risk for higher rewards.
2. Bonds: You are acting as the lender, and you are loaning money to different institutions (e.g. government, corporations). Bonds are typically viewed as a way to smooth out the volatility of equities, providing more stability to your portfolio.
3. Cash: You’re always going to want to have some cash. There’s a reason cash is king- having ready cash available at the drop of a hat is pretty powerful.
4. Real Estate: This can be anything from a single family home that you rent out to REITs (real estate investment trusts), which are traded on the market if they are public. This can potentially make up a big part of your assets if you’re the type that is really into real estate.
5. Commodities: These are goods that are interchangeable- think agriculture (wheat, livestock), metals (gold, copper), and natural resources (oil).
These asset classes are supposed to work independently of one another. Remember the idea of not holding all of your eggs in one basket? This is the idea behind diversification: you want to make sure that you are diversified in regards to your asset classes. You may also want to diversify within your asset classes.
Why is diversification so important? Because each of these asset classes behave differently from one another. It would be wonderful if the stars aligned and we could find a way for all asset classes to produce a sky high rate of return at the same time forever and ever. But we have to deal with reality here: some asset classes will be rocking it while others will show a negative return. Accept this fact and move on, because there is only so much one can control and try to predict.
Your job: to find the right mix of assets to construct your portfolio. Your choice will depend on many factors, such as your age, your risk tolerance, your time horizon, your overall financial situation, and what you like to invest in. You will then need to rebalance this portfolio as time goes on, as younger people can take on more risk while those nearing retirement will want to decrease their exposure to riskier assets.
But I want to know the best asset allocation! You must have a formula for me, right?
Sorry, there’s no magic formula that’s going to work for everyone. I’ve already listed 5 factors that will influence your asset allocation. Everyone’s situation is different, and what works for one person isn’t going to necessarily work for another.
Take a young veterinarian that just graduated. His asset allocation is going to look different from a veterinarian that has been out for 20 years and owns a practice.
However, the White Coat Investor has done the laborious task of gathering 150 portfolios that you can peruse at your leisure. Take a look to get an idea of what different portfolios look like.
WHAT DOES YOUR PORTFOLIO LOOK LIKE NOW?
Speaking of which, do you even know what your portfolio looks like right now? In my case, I knew where my investments were, but I didn’t bother putting it all together as one big picture until relatively recently. So gather up those retirement accounts (IRAs, workplace retirement accounts like 401k’s) and your taxable accounts.
Don’t have either? Don’t worry- I made the big mistake of not opening up a retirement account right after graduation. I could have theoretically opened up an IRA even earlier, since I had earned income starting from high school, and I had worked throughout college and vet school. What’s done is done- all you can do is control what you do moving forward.
If you do have a retirement account +/- a taxable account, figure out which assets you have and calculate their percentages as a part of your entire portfolio. This is your asset allocation. Is this an allocation that you’re happy with?
If you don’t know, you can do one of two things. You can either take a bit of time to educate yourself so that you can be a DIY investor (the Bogleheads website is a good starting point), or you can turn to a financial advisor to assist you. Notice the word “assist.” Do not go to a financial advisor with no prior knowledge about investing and blindly follow whatever plan they make for you. Being an informed client will be much more helpful to you and your advisor.
Do you have any additional resources that you have found helpful regarding asset allocation? Comment below!
Asset allocation is a great way to diversify. You are right that there is no magic formula that you can just tell people this is what you need to put it in. A lot of circumstances go into making the right decision (your risk profile, your current financial state, your age).
Unfortunately, most people just want the formula (myself included!). Wish it were that easy!