Monday, December 21, 2009

Asset Allocation: Part 1

Asset allocation is one of the most important investment topics to understand.  At the top level, asset allocation is how you split your money between cash, bonds and stocks, each of which is a separate asset class.  There are other asset classes, like real estate and gold, but when you're getting started, you mainly need to focus on cash, bonds and stocks.  There are also further subdivisions of stocks and bonds into additional asset classes, but I'll save that for Part 2.

(Note that by "stocks and bonds" I really mean low cost stock index mutual funds and bond mutual funds, but I'll continue to simply refer to them as stocks and bonds.)

An asset class is characterized primarily by its risk and return, and how it tends to perform relative to other asset classes (how similar are the ups and downs).  For example, in the short term, cash is the least risky asset class, stocks are the most risky, and bonds are somewhere in between.  However, over longer periods of time, stocks have usually (but not always), provided a higher return, with bonds coming in second, and cash coming in last.  So, although it may feel safe to hold cash, in the long run it can actually turn out to be riskier than stocks, in the sense that the purchasing power is reduced by inflation, whereas stocks have tended to outpace inflation in the long run.

Also, bonds sometimes go up when stocks go down, and the up and down movement of bonds is usually less dramatic than stocks.  Of course the nominal value (before inflation) of cash doesn't move up or down, but just maintains its value, although cash is almost guaranteed to lose value over time to inflation.  So in addition to having different risk profiles, these asset classes don't tend to move up and down together, which is fundamental to them being considered different asset classes.

I've discussed cash in a previous post (Your Cash Stash, December 9, 2009), so I won't get much into that here.  You'll want to have some minimum allocation to cash for emergencies and shorter term spending needs, but your longer term investments should be in stocks and bonds.

Your allocation between stocks and bonds depends on your need, ability and willingness to take risk.  For example, you need to take more risk if you don't have much money saved for retirement, you have more ability to take risk if you are young and/or if you have a stable job or other source of income, and your willingness to take risk depends on how well you can tolerate significant fluctuations in the value of your investments while sticking to your investment plan and still being able to sleep at night.

A common rule of thumb is to allocate to bonds a percentage equal to your age.  So, if you are 25, this rule of thumb would dictate allocating 25% to bonds and 75% to stocks.  Here I'm assuming that you already have an appropriate cash stash, so am not including that in the asset allocation.  Some financial gurus advocate allocating even more to stocks when you're younger, because historically stocks have always outperformed bonds over 30-40 year timeframes, and when you're in your 20s, your investment timeframe is 50-60 years (your investment timeframe extends at least until you die, not just until you retire).  However, no one knows if this will be true in the future, although it's reasonable to assume that the global economy will continue to grow, and that owning shares in the businesses that are growing along with the economy will be profitable.

The "age in bonds" rule of thumb is just that -- a rule of thumb.  There are other factors to consider, but it's a good place to start.  I would encourage young people with good job skills that are likely to be in demand for many years (i.e., young with little savings = higher need to take risk, likely employment stability = higher ability to take risk) to allocate more to stocks.  Still, I would suggest keeping some extra cash or bonds as a source of funds to buy more stocks if there's a big market plunge.  Also, if you're planning a major purchase in the next few years, you want to keep that money in cash or a short term bond fund.

Having said this, you can't ignore your ability to tolerate potentially large declines in the value of your investment portfolio (willingness to take risk).  If you're going to freak out when your investment portfolio declines in value by 30%, and sell all your stocks, then your willingness to take risk is fairly low, and you should reduce your stock allocation accordingly.

A common rule of thumb is to be prepared for losses up to 1/2 of your stock allocation.  So, if you have 80% in stocks, be prepared for up to a 40% decline in your portfolio value.  It's really important to carefully visualize this happening, and determine if you'll have the fortitude to stick to your investment policy when it happens.  It's a lot easier to imagine it than to actually live through it, as many people have recently discovered.  You should certainly be prepared for 10%-20% declines in the stock portion of your portfolio many times over a lifetime of investing, and larger declines a number of times.

When these declines occur, and they will, you must remember that you're investing for the long run, and that historically most markets have eventually recovered from these declines in a reasonable amount of time.  However, there have been periods of many years in various markets and asset classes where returns have been poor, which is a reason to diversify more broadly -- I'll get more into that in Part 2 of this topic.

If you follow something like the "age in bonds" rule of thumb, you'll gradually shift your asset allocation to less stocks and more bonds as you get older.  By age 50, your allocation would be 50% stocks, 50% bonds.  By the normal retirement age of 65, you would be 35% stocks and 65% bonds.  The idea here is that as you get closer to retirement, you have less time to recover from a major market downturn before you start living off of your investments, and you have fewer years to generate income and savings that you can use to buy more stocks when the market is down (i.e., when stocks are "on sale").  If you only have 30% in stocks, then a 50% decline in stocks is likely to result in something like a 15% decline in your portfolio value, which is much more tolerable at age 70 than the 40% decline that a 25 year old with an 80% stock allocation would be experiencing.

Getting back to the need to take risk, if you have enough money, you can afford to have a lower stock allocation than using the "age in bonds" rule of thumb.  It would be unwise for someone who's been fortunate enough to save enough to live off of for the rest of their life, invested mostly in cash and bonds, to have a high stock allocation.  A saying I've heard to describe this is that you get rich by taking risk, but you stay rich by minimizing risk.

To summarize, although there's no guarantee, stocks have usually provided the highest long term return among the three major asset classes of stocks, bonds and cash.  Therefore, when you're relatively young, you are likely to be rewarded by consistently investing the majority of your savings (what you earn minus what you spend) in low cost stock index funds, while balancing that with some percentage in a low cost bond fund, and maintaining an adequate cash allocation to meet your emergency and shorter term spending needs.  Then, as you age, gradually shift your allocation to more bonds and less stocks, always considering your need, ability and willingness to take risk.

In Part 2 (which probably will be my next post), I'll discuss the next level of asset allocation; i.e., different types of stock and bond funds, and how further diversifying amoung these lower level asset classes is likely to provide greater returns while taking less risk.

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