Asset Allocation-What it is and Why it’s Important

This week there had been several posts about Derek Foster selling out, Canadian Capitalist and Four Pillars were two blogs posting on him, one of the major issues with his portfolio was that he had 100% equity allocation. So I thought this would be a timely post to discuss importance of asset allocation.

Asset allocation is by far the most important part of any investment portfolio, Ibbotson and Kaplan have shown that 90% of portfolio variability is due to asset allocation. This means that only 10% of your portfolio performance is due to your individual holdings while 90% of it is determined by how you have allocated your money. This goes to show the importance of asset allocation. Stocks and bonds usually move in different direction so having a mix of both will reduce the volatility of your portfolio and provide you with better return than just 100% stocks or bonds. Derek Foster unfortunately did not understand asset allocation and the fact that having a mix of both provides a better return than just 100% stock or bonds this is known as the efficient frontier.

Many novice investors either do not know this important fact or forget about it, in here I hope to shed some more light on asset allocation. Now we know how important asset allocation is, let’s take a closer look at what this important term (asset allocation) is and how you can determine your proper allocation.

What is Asset Allocation:

In simple terms asset allocation is how you divide your investments between different categories, these being equities, bonds and cash. It is usually tied to your risk tolerance, personal and financial situation and many other factors which combined determine your investor profile. The Financial Blogger has a post on investor profile.

Asset Allocation Models:

There are some general “asset allocation models” these are designed to help investors and advisor in categorizing their preferences. Think of asset allocation as a highway, like the 401 going from Toronto to Montreal and each lane on the highway as on of the asset allocation model described below.

1. Capital Preservation

This is for investors who intend to use the money sometime in the near future 12-24 months. This could be for house down payment, car payment, education, a trip or anything else that would require the money to be there in its whole. This is not really invested money, it usually sits in a savings account or some short-term guaranteed investment such as government bonds. The goal is to protect your capital and earn a very small amount of interest. This is like a parking lot or pit stop on your way to your destination, you have almost reached it and are just waiting for someone to arrive, you basically are standing still.

2. Income

The income portfolio is designed for those who need the income from their investment. It usually is retirees but could be anyone who needs the income from their investment for any purpose. The majority of the investments are in income generating vehicles such as government and corporate bonds, Income Trusts and sometimes blue chip dividend paying companies.  The investor is not concerned with growth but wants the safety of income hence the heavy bond weighting. This is the first lane of the 401 you are almost there and just taking it easy and enjoying the view. Chances of you getting in an accident are very low to zero and if you did it would not cause a big damage.

3. Balanced/Income-Growth

Probably the most common model used is the Balanced model. This is where part of your investment is in the growth category and part is in income category, this doesn’t always have to be 50-50 split in fact most often it is a 60% equity and 40% bond split. This model aims to provide some capital protection as well as growth opportunities, pretty much anyone can fall into this category as it provides somewhat more stability. This is the middle lane where you are half way through and you are driving at normal speed to get to your destination. There is a chance you could get in an accident but if you do you wouldn’t be hurt badly since you are driving at normal speed limit and careful.

4. Growth

This is a more aggressive model, it aims to provide capital appreciation with no or little income. A typical investor is a young employed individual who is looking to increase their networth and do not care much about income or capital preservation. Types of investments held in here are mostly growth stocks maybe some small portion of dividend stocks and bonds. This is the last lane of the highway you are in a bit of a hurry and are driving slightly over the speed limit to get to your destination, you probably driving a sports car. If you get in an accident you could get hurt pretty bad, although chances of accident are high you are driving careful.

5. Aggressive/Speculative

This is the most aggressive model and not many investors fall in this category and they shouldn’t. I think this is more speculation than investing, the investor in this category is in for the quick buck. Types of investments are small start-up companies or a company in bankruptcy protection or major lawsuit basically in some type of distress where the outcome is very speculative. There generally is no fundamental analysis it’s just a gamble. This is you driving on the shoulders of the highway and zig-zagging through other cars, you drive careless and try to set a new record for how long it takes to get to Montreal from Toronto. If you get in an accident chances are that you will not survive it or suffer a permanent injury.

As you can see the risk increases as you go down the list, I hope my highway model makes it a little easier to understand. Some firms also have other sub-categories within the main categories, these are the main Asset Allocation models.

Re-balancing

Overtime your asset mix will shift, your equities may outperform your bonds and this will shift your original asset allocation so every ones in a while you will have to do what is called a rebalancing of your portfolio to bring it back to its original goal allocation.

How to Determine you Asset Allocation

There is no right or wrong answer to this or a simple answer, your asset allocation depends on many things. Some important factors that effect your Asset Allocation are:

  • Your Risk tolerance: How much volatility can you handle? The lower your risk tolerance the lower your equity allocation.
  • Your Time horizon: How long till you’ll need the money? The longer you have the more equity you can hold.
  • Your Financial situation: If you lost all your investment can you still keep up your standard of living?

Although there are some other criteria that go into determining asset allocation these are the important factors.

Determine your investor profile

My Asset Allocation

Although I am younge and far from retirement and fall in the Growth Cateogry according to my investor profile, I prefer dividend growing, blue chip companies with small allocation to growth companies. My “normal” Allocation is 70% Equity 25% income and 5% cash & eqiuvalents. However currently due to my wedding coming up and planned home purchase my allocation has shifted to 5% equity 95%cash, and all my holdings are dividend paying companies most recently sold off my REIT holding (RioCan) I am moving to 100% cash within the next couple of months.

What does your asset allocation look like?

4 Responses to Asset Allocation-What it is and Why it’s Important

  1. Pre 2008 crash I was at 60/40 (bond/equity). I have been shifting my allocation as the markets come down further and I’m at 5/95 now. It’s very aggressive but I’m looking at 25-30 years until I need the $. As the markets go up (hopefully) I’ll be shifting in the opposite direction.

    I’m surprised your moving to cash at this point or did you do this before the crash?

  2. PLS wow that is pretty aggressive move there specially for the long term could be very volatile but for the next few years it might be a good strategic allocation.

    I had to move to cash mainly due to couple of big expenses I have coming up.

    1. Wedding this summer
    2. Planning on purchasing a condo

    Personal account I was mostly in cash since February 08, I saw some opportunities in the market in December with the tax-loss selling specially in financial sector, now pretty much sitting back on 100%. sold off some financials in the market rally this week.

  3. Good post on the basics of asset allocation. While asset allocation is not a magic formula for success, for many investors it is a way to implement a sell discipline. Buying a stock or fund at the right time is much easier than knowing when to sell. Periodic rebalancing enforeces a basic sell discipline.

  4. Ray – Its very hard to find quality articles on asset allocation and rebalancing. This is a really excellent article and I plan on referencing it on future articles I write. The only think I would like to add is investors should consider a tactical or active asset allcation strategy. This allows for a flexible asset allocation when rebalancing depending on asset category valuations.
    Thanks Again.
    Ken Faulkenberry

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