What does the term asset allocation mean? What should mine look like?

January 24, 2020, by John Norris

Asset allocation is an investment strategy that whether they know it or not, every investor uses. Asset allocation essentially is the diversification of a portfolio across non-correlated asset classes that will produce the maximum return for the risk that an investor is willing to take on.

We all know that over time, stocks generally outperform bonds. The increased risk that an investor takes by purchasing an equity demands a greater level of return. This leads people to ask, “well why don’t I just buy all stocks if they have the highest historical return?” The reason this might not be smart for all investors is the same reason that stocks generally have a higher rate of return. More risk. In a downturn or a recession, stocks are going to vastly underperform bonds. In fact, many bonds will make money during a recession! This is the beauty of a non-correlated portfolio. When some investments go down, other investments will go up. This is essentially a way to hedge risk in a portfolio, or try to prevent as much downside as possible.

This brings up a second question for many investors, “well what should my asset allocation be?” It has been said that your age should be the percent of your portfolio that is in bonds. And while the real answer is much more complex than this, it gives us a good idea though of the questions we should be asking ourselves about our allocation and how it is fluid over time. Questions will include things like, do I have any additional income, how dependent will I be on this money, and is this enough currently for me to retire. To put it in broad terms though, the main questions are, “how much can I withstand the portfolio to decrease in a downturn?”, and “how much do I need the portfolio to grow?”

Understanding these questions will give us a better idea of what a portfolio’s optimal asset allocation is. If your goal is to retire in a few years, and the current amount is enough to comfortable retire. The correct allocation is probably somewhere more on the conservative side. However, if you are trying to retire soon yet you need the portfolio to be larger to retire comfortable, something more aggressive than the former scenario probably makes sense.

This is where an investment advisor can come in and help. These examples are overly simplified for explanations sake. The variables that go in to answer the question of what the correct asset allocation is are endless, and an advisor who is trained in both asking the right questions and interpreting the answers can help individual’s get their portfolio to a suitable range for their unique circumstances.

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