Asset Allocation
Asset allocation is the decision about how much of each asset or investment do you want to hold. It’s the fancy way of saying ‘don’t put all your eggs in one basket’. To understand why it’s so popular we need to introduce a few concepts.
Correlation
The reason asset allocation can help is the basic idea that if you’ve spread yourself across lots of different things, then if one’s down another one may be up. The movement of different asset classes in relation to one another is called correlation. If two things are positively correlated, they move in the same way. If they’re negatively correlated, they move in opposite directions. To reduce your risk by asset allocation, you need assets that are negatively correlated- it’s only any use holding more than one if they behave and move differently.
The most common asset allocation split incorporates the main asset classes:
Cash
Bonds
Stocks
Cash doesn’t really ever move, (apart from being eaten by inflation) so you only need to worry about the other two. Based on historical averages stocks and bonds are negatively correlated- so as one is going the other is going down. So owning some of each can balance your returns. Bonds are less risky and less volatile, so typically they’re the ‘flight to safety’ when investors are panicking and selling stocks.
Diversification
The number and types of assets you hold will depend largely on how much risk you’re willing to take. Typically in order to generate higher returns you need to take more risk, so a higher weighting to the more volatile asset classes.
You may also have other entirely non-correlated assets in your portfolio like property, gold etc. Determining how much to hold of each is entirely personal preference. I find always the best approach is to ensure you’re comfortable with the typical ranges of returns of an asset class, and using that to guide your decisions. For example as an equity investor, you have to be prepared to see your investments halve in a reasonably short space of time, given that’s an entirely possible outcome. For bonds, you need to be willing to see them down perhaps 25%, though there you still have the security of getting your money back at par if things don’t go horribly wrong.
Most investment advisers set asset allocation based on your acceptable risk level (arbitrarily defined as ‘Aggressive, Conservative etc) or your age. If you’re young you can take more risk, because if asset prices fall you’ve got lots of years to make the money back. If you’re retired and living on this portfolio as your only income, you don’t want to see it halve in a year, as you may not have sufficient life yet for it to recover and that may be too much of an income hit for you take.
The typical approach they’ll take is 100% risky assets like stocks when you’re young, and then gradually introducing more lower risk assets like bonds over time as you get older, so by the time you’re 70 the portfolio will likely be largely bonds entirely. There’s nothing inherently wrong with this approach, it’s logical and fine for many people, it’s just a little blunt.
Rebalancing
When you’ve got your asset allocation decided, you then need to decide how often you’re going to rebalance. Let’s say you hold 80% stocks and 20% bonds- if stocks go up 20% and bonds fall 5% you’re going to find yourself holding more than 80% stocks, and less than 20% bonds- so should you sell stocks to buy more bonds?
Rebalancing is often approached on a fixed basis- perhaps once a quarter. I would suggest any more frequent than that and you’re just wasting time and transaction costs. A more pragmatic approach is to use thresholds or ranges- once an asset becomes +/-5% of where it should be, perhaps that’s the time to rebalance. In volatile markets that may mean you’re rebalancing more often, and in calm markets very little at all.
Investors with a particularly momentum focussed mindset will likely balk at the concept of selling something that’s doing well, but that’s the best time to be doing it. Buy low sell high.