Asset allocation. It’s so ingrained in how we manage our clients’ investment portfolios, we talk about it all the time. But what exactly is asset allocation?
Asset Allocation: A Classy Subject
Big picture, an asset is anything beneficial you have or have coming to you. For our purposes, it’s anything of value in your investment portfolio. After bundling your investable assets into asset classes, we allocate, or assign, each asset class a particular role in your portfolio.
To offer an analogy, allocating your portfolio into different asset classes is similar to storing your clothes according to their roles. Most of us sort our clothes (pants, shirts, shoes, etc.), instead of just leaving them in a big pile in your closet. You may also further sort your wardrobe by style, so you can create ideal ensembles for your various purposes. Likewise, asset allocation helps us tailor your portfolio to best suit you. Your precise allocations are guided by your particular financial goals.
That’s it, really. If you stop reading here, you’ve already got the basics of asset allocation. Of course, given the academic brain power behind these basics, there is plenty more we could cover. For now, let’s take a closer look at those asset classes.
Asset Classes, Defined
At the broadest level, asset classes typically include domestic, developed international, and emerging market versions of the following:
· Equity/stocks (an ownership stake in a business)
· Bonds/fixed income (a loan to a business or government)
· Hard Assets (a stake in a tangible object such as commodities or real estate)
· Cash or cash equivalents
Just as you can further sort your wardrobe by style, we can further subdivide each broad asset class (except for cash) based on a set of factors or expected sources of return. For example:
· Stocks can be classified by company size (small-, mid-, or large-cap), business metrics (value or growth). Also, by a handful of added factors recently identified.
· Bonds can be classified by type (government, municipal or corporate), credit quality (high or low ratings), and term (short-, intermediate-, or long-term due dates).
We can then mix and match these various factors into a rich,but manageable collection of asset classes – such as international small-cap stocks, intermediate government bonds, and so on.
Generally speaking, the riskier the asset class, the higher return you can expect to earn by investing in it over the long haul.
Asset Allocation, Implemented
To convert plans into action, we turn to select fund managers with low-costs fund families that track our targeted asset classes as accurately as possible. Sometimes a fund tracks a popular index; other times, funds track asset classes more directly. Either way, the approach lets us turn a collection of risk/reward “building blocks” into a tightly constructed portfolio. We optimize asset allocations to reflect your investment plans.
The Origin of Asset Allocation
Who decides which asset classes to use, based on which market factors? To be honest, there is no universal consensus on THE correct answer to this complex and ever-evolving equation. As evidence-based practitioners, we turn to academics, professional collaboration, and our own analyses. Our goal is to identify allocations that best explain how to achieve different results with different portfolios. We look for robust results that have:
· Been replicated across global markets
· Been repeated across multiple, peer-reviewed academic studies
· Lasted through various market conditions
· Actually worked, not just in theory, but as investable solutions, where real-life trading costs and other frictions apply
Asset Allocation in Action
As we learn more, sometimes we can improve on past assumptions, even as the underlying principles of asset allocation remain our dependable guide. Employing sensible, evidence-based asset allocation to reflect your unique financial goals should better position you to achieve those goals over time.
Asset allocation also offers a disciplined approach for staying on course toward your own goals through ever-volatile markets. This is more important than most people realize. As Dimensional Fund Advisor’s David Booth has observed, “Where people get killed is getting in and out of investments. They get halfway into something, lose confidence, and then try something else. It’s important to have a philosophy.”
So, now that you’re more familiar with asset allocation, we hope you’ll agree: Properly tailored, it’s a fitting strategy for any investor seeking to earn long-term market returns. Please let us know if we can tell you more.