Asset allocation refers to the risk-balancing and reward investment strategy by deciding the proportion of your portfolio or net value to be invested in different asset classes.
A smart approach to asset allocation is much more important for most investors than the individual stock collection. Getting right is a key thing and an environment where many investors have been losing their returns.
This is because it is very difficult to pick individual stocks that significantly outperform the economy, while simply juggling the money between domestic stocks, foreign stocks, shares, real estate, precious metals, and other asset classes helps to cut risk sharply and sustain growth over different market conditions.
Pros of Asset Allocation
Asset allocation essentially means a diversification of the portfolio. The ideal objective with proper asset allocation is to maximize a portfolio’s risk-adjusted returns, and tailor its growth potential and risks to the needs and objectives of an individual investor.
Domestic and International equities
Essentially, various regions of the world are witnessing different periods of great performance and bad performance. One zone is sometimes overvalued while another is undervalued. Changes in currency exchange rates often play a major part for or against international equities.
Passive investors can easily get a large US market exposure to very low costs by holding the Vanguard Total Stock Market ETF (VTI).
The biggest mistake that investors make is that they focus heavily on high-debt low-crowd economies, such as Japan and Germany, and not enough on some of the larger developing markets or developed countries.
In the case of a stock market crash, bonds help to reduce portfolio uncertainty. When interest rate fluctuations tend to be reversed to some degree with inventories.
In the current era, the problem with bonds is that their interest rates are so low, making them less desirable of an investment than they were decades ago.
In addition, another way to put it is by overvaluing bonds. Compared to historical standards, their interest rates are very low for the different risks that creditors take on when locking up their money lending to businesses or governments.
Real Estate & REITs
In general, real estate assets generate stable cash flows, pay high dividends, make great use of cautious leverage and act as a strong defense against inflation.
Whether you owe real estate investment trusts (REITs) in a portfolio depends on how big your real estate exposure is outside of your portfolio.
If you have a large percentage of your net worth in your primary home and/or an investment property, then you may not need much of your liquid portfolio, or any real estate.
On the other hand, if you are not a homeowner and have little or no real estate assets outside your portfolio, then a large allocation to REITs in a portfolio makes sense for you to have some exposure to real estate.
Speak of it like this. Around 25-30 per cent of assets in the United States are real estate. I think that many other nations are weighing up real estate even more than that.
If you have less exposure than that within your net worth, you’re underweight real estate between your home and your investments. That is not inherently good or bad but to be conscious of it is a standard.
Precious Metals & Commodities
Another controversial topic is whether gold and silver should be included in a portfolio.
A lot of investors, including myself, like having at least some exposure to them as part of a fully diversified asset allocation strategy.
Many countries around the world have undergone crashes in currencies, economic depression, and other significant instability, and having some exposure to gold will greatly help them through those rough times.
Investing in gold has the advantage that it is largely uncorrelated to everything else. And there is no credit risk to counter-parties for precious metals like there is for bonds. Gold and silver were used as currencies, and for thousands of years were used to store money.
Other types of commodities or commodity producers may also occasionally give a portfolio some additional diversification. Historically, however, commodities have been one of the tougher asset classes to make a profit from, so it pays to be very careful.
Cash plays a useful role when bonds do not offer a good risk-reward ratio, and are also useful when setting up a liquid emergency fund.
It is important for people to be able to pay unexpected expenses, or deal with an unexpected income loss, without tapping into their core portfolios. During bad times having to sell stocks or other properties will lead to unnecessary additional taxes and fees.
Asset Allocation Approaches
There are two main approaches to Asset Allocation
1. Strategic Asset Allocation
2. Tactical Asset Allocation
Strategic Asset Allocation means holding a diversified, neutral portfolio, and not changing the allocations based on market conditions. You’re just holding in, adding money, and rebalancing.
Diversified passive buy-and-hold investment is a simple way for many people to build wealth.
For this approach, you are building a diversified portfolio of index funds or ETFs, and periodically re-balancing.
In other words, if one asset class goes up and another goes down, you are selling some of the higher asset class and purchasing the dip in the underperforming asset class to keep the same weighting over time.
The only thing that changes over time with portfolios that pursue an approach to allocating strategic assets is that they may become more conservative over time.
Young investors are usually told to start with high stock allocations, and then the stock allocation within their portfolio slowly decreases over time and the bond allocation increases.
If you want to get going, then there are several choices.
- Betterment is one of the most common ways to invest with strategic allocation of assets, in particular for taxable accounts. This is a robotic consultant; it asks a series of questions about you and then helps you invest in a portfolio that is tailored for your age and other variables with growth and risk. Tax-loss recovery is the key benefit for taxable accounts at robo-advisers such as Betterment. Through clever tweaking of your wealth, the program minimizes capital gains taxes as it rebalances them over time.
- An investment in one of the Vanguard LifeStrategy Funds is arguably the best option for retirement accounts. They allow you to automatically invest in a diversified portfolio with domestic stocks, foreign stocks, and bonds that re-balance themselves automatically.
Tactical Asset Allocation is more sophisticated, relating to the constructive modification of your weightings to different asset classes based on leverage or projected returns from those asset classes.
Tactical asset allocation is a more hands-on strategy in which you change your allocations to different asset classes depending on where you believe there are good market risk / reward ratios.
The downside is that you can reduce your uncertainty significantly and increase your returns marginally. It is more prone to human error, however, and if done poorly, your returns will be reduced.
Having a balanced and thoughtful approach to asset allocation in your portfolio is the main way to make an investment success.
I am gradually diversifying away from U.S. equities in this market of rising asset prices, undoubtedly late in the business cycle, while still maintaining decent exposure to them.
Emerging markets, including some of the countries with the lowest debt levels, are traditionally very cheap-priced right now. Commodities which include gold and silver are relatively cheap.