Invest with Confidence: The Importance of Asset Allocation

If you haven’t managed your finances and investments before, it can seem overwhelming.  There is a lot to learn, and the industry is filled with jargon so it’s not totally intuitive.  But it is doable and is easier than you may think.  There are a couple of important concepts to understand when it comes to managing investments, the most important of which is asset allocation.  Asset allocation is simply how much you invest in stocks vs. how much you invest in bonds.  And it is the single most significant determinant of your investment returns. 

Why Do I Care About Stocks and Bonds

So why does it matter what you invest in stocks and what you invest in bonds?  Well, it has to do with risk.  Stocks give you the most opportunity for growth, but they are also the most volatile.  Meaning they go up and down in price, sometimes a lot.  One day, you might have a stock that is worth $20 and the next day it’s only worth $5.  Generally, the value of the stock is based on the underlying performance and value of the company that issues the stock.  But with our 24-hour news cycle and focus on the markets, headlines can cause a stock to go up or down (at least in the short term) in a way that is not justified by the underlying value.

Bonds, on the other hand, are a more stable investment.  With a bond, the company is basically borrowing money from you and paying you interest in return.  As long as you hold the bond to its maturity date (and the company does not go out of business) you will collect all your monthly interest payments and then get all of your money back at the end.  And there are even companies that review the financial health of bond issuers and provide credit ratings to investors so you can buy bonds only from the most creditworthy (i.e., less likely to go out of business) companies.

The Tortoise and the Hare

You might be wondering why you would invest in stocks if bonds are so much safer.  And the answer to that is: potential return.  While bonds are relatively safe, they are kind of like the slow and steady tortoise.  The interest they pay is based on the interest rate at the time the bond was issued.  While it generally beats the rate you are getting in a savings account at the bank, it’s never going to significantly grow your assets. 

Stocks, however, are more like the speedy hare.  A stock can go up 5, 10, 15, 20% or more in a single year (don’t forget – they can also go down by these amounts).  In fact, the average return of the S&P 500 (the 500 largest US companies) is nearly 10% per year over the past twenty years.  You want to have stock in your portfolio to give you the growth that makes investing so powerful.

As I mentioned before, your asset allocation will be the mix of stocks and bonds that you choose to invest in.  You frequently hear about the 60/40 or 70/30 portfolio.  In this language, the first number is the percent of your portfolio that is invested in stock while the second number is the percent invested in bonds.  The higher the stock number, the more overall risk in the portfolio.

The key is to determine the right mix of stocks and bonds for you, based on your specific goals, your timeline, and your risk tolerance.  So how do you determine the right allocation for you?

Assess Your Financial Goals

The first step in determining what your asset allocation should be is defining your short-term and long-term financial objectives.  Consider factors like retirement, education expenses for your children, and any other major life events.  Your investments are probably earmarked for a number of goals, all with different time-horizons.  If you don’t know what you are ultimately investing for, then it is impossible to determine the right asset allocation.

Time Horizon Matters

Depending on what you are investing for, you will have different time horizons and therefore different asset allocations.  For example, say you want to buy a house in two years, and you want to invest the money you are saving for a down payment until that time.  That would be considered a short-term goal and would require a conservative asset allocation.  Compare that with investing for retirement.  If you have ten, twenty or even thirty years before you plan to retire and start using your savings, you can have a more aggressive asset allocation because you have more time to let your assets grow and to recover from the market’s inevitable ups and downs.

Generally, anything under two years is considered short-term and should be very conservatively invested.  Time frames from two to ten years are intermediate and can be moderately invested.  While time frames greater than ten years are considered long term and can be more appropriately invested with a higher level of risk.

Risk Tolerance

Risk tolerance refers to how much risk you, as an individual, can handle.  This is different from person to person and is very emotional.  Clients often ask what their risk tolerance should be, but that is not a question your advisor can answer.  It’s something that is based on your personality and lifetime of experience.

While there is no one way to measure risk tolerance, you should try to understand whether you are more comfortable with investing risk or less.  One way to know is based on your reactions to financial news.  Assuming you hear that the market is going up or down, how likely are you to react and either buy or sell investments?  If you react quickly to the news, or lose sleep based on headlines, then you are likely less risk tolerant and should consider a more conservative allocation.  Alternatively, if you can ignore the headlines or feel comfortable with the ups and downs in the market, then you are likely more risk tolerant.  You are probably going to be more comfortable taking on more risk.

One caveat to keep in mind – your risk tolerance may change during times of transition. While you may not have been that worried about risk when you were married, now that you are managing things on your own, it’s possible that you are feeling more conservative.  That is completely normal and something you should honor.  Just listen to your instincts and adjust accordingly.

Regular Review and Adjustments

While you will want to determine your asset allocation when you setup your investments, your financial situation may change over time. Periodically review your asset allocation to ensure it aligns with your current goals and circumstances.  Additionally, as the market moves, so will your asset allocation.  If you don’t check-in and rebalance periodically, you can end up taking on much more (or less) risk then you want over time.  Make it a point to review your portfolio at least twice a year and make sure it is still aligned with your goal allocation.  It’s ok if it’s within 5% of your goal, but anything beyond that and you will want to rebalance to bring it back in line with your target allocation.

Your Allocation is Key

Determining the appropriate asset allocation will go a long way to helping you be a successful investor.  Asset allocation determines over 90% of the returns of a given portfolio.  As such, you want to make sure that you have the right allocation for you.  You can determine the right allocation for you by considering your goals, time horizon and risk tolerance.  And don’t forget to check in periodically to make sure things are still where you want them to be.

If you have any questions or would like personalized assistance with your financial planning, please don’t hesitate to reach out. Your financial well-being is our top priority.