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Why is Asset Allocation Important? The Most Crucial Investment Concept

By in Asset Allocation, Bond, Investing, Mutual Funds, Stocks | 15 comments

MBA Series – What Makes Asset Allocation So Important?

“Don’t put all of your eggs in one basket.”

The beginning of the year is portfolio rebalancing time for investors. I write a lot about investing as it is an achievable path to long-term wealth. If you don’t know what asset allocation is or much about investing at all, then this article is for you.

Modern Portfolio Theory is the science that drives most of the writing about investing today. As I put the finishing touches on the university Investments class I’m teaching, I’m going to share some of the basics with you.

Why is asset allocation the most important investment topic?

Asset Allocation means selecting specific asset classes and choosing the percentage amount invested in each asset class.  Sample asset classes are:

    • U.S. Stocks
    • U.S. Bonds
    • International Stocks
    • International Bonds
    • Real Estate or REITs
    • Government Bonds
    • Small Cap Stocks
    • Large Cap Stocks
    • Government Bonds
    • and more

Diversification – Tried and True Investing

Diversification in investing means don’t put all of your money in one investment or one type of investment.

Why?

When that investment goes down, there goes the value of your invested assets-down. And vice versa.

Buy different types of investments, so that when one goes down in price, the others may go up, or at least remain stable.

Diversification smooths out the ups and downs of the value of your investments.

For example, it is rare for bonds and stocks both to go down at the same time. During certain years, bonds will outperform stocks and others stocks outperform bonds.

Take a look at returns of the S&P 500 stock market index in comparison with the returns of the 10 year Treasury bond during the previous 10 years.

Over long periods of time stocks have outperformed bonds, but a combination of both asset classes reduces your portfolio volatility (as measured by standard deviation). Notice that last year, the S&P 500, a proxy for the stock market averaged 11.74% return, while the 10 year Treasury bond returned a paltry 0.69%. Then, travel back in time to 2008 when the S&P 500 sunk a disastrous -36.55% and the 10 year Treasury bond enjoyed a 20.10% return. 

With an all-stock portfolio, in 2016, you would have enjoyed an 11.74% return and a -36.55% decline in 2008. But, diversify a bit and the gain in 2016 wouldn’t have been as great, but neither would your losses have been as devastating in 2008.

Here’s Why Asset Allocation Is Important

Over the past 10 years, an all-stock portfolio would have earned an average 8.75% return, but with great volatility, as measured by the 18.74% standard deviation. Just think about how you might have felt in 2008 with a negative 36.55% return or in 2011 with a 2.10% stock market return while the 10 year Treasury bond advanced 16.04%. 

Now, diversify with 70% of your money in stock market investments and 30% in bonds and over the past 10 years, you’d still have a respectable 7.63% return, but with a much tamer 10.87% standard deviation. You’re worst return year would still be painful, at -19.56% in 2008, but certainly better than the -36.55% drop.

Bonus: How to Build an Investment Asset Management Strategy >>>

Simple Portfolio Management for Successful Asset Allocation

The research abounds that a basic asset allocation of a certain percent in stock investments and a certain percent in bond investments has led to long term wealth creation.

As previously mentioned, there are all types of asset classes such as international stocks, country-specific stocks, small cap stocks, commodities, real estate, corporate bonds, government bonds, international bonds and more. All of these types of assets can be bought as individual holdings, or combined in mutual funds and exchange-traded funds (ETF). But, you don’t need to worry about the wide variety of asset classes unless you are passionate about investment management. You can obtain a satisfactory amount of diversification with just two ETFs or mutual funds.

For those DIY investors, seeking a simple two asset class investment portfolio, you’ll get sufficient diversification with part of your money in the Vanguard Total World Stock Index ETF (VT) and the remainder in the iShares Barclays Aggregate Bond Index ETF (AGG). 

Index funds and ETFs are perfectly suited to a simple and effective portfolio management approach. The two asset portfolio shown in the chart above combines a world stock market index ETF with a total US bond fund. Depending on your age and risk tolerance, place more or less in each asset class.

With annual rebalancing to make sure the percentages in each asset class remain in alignment with your stated preference, you can grow your assets with little time spent in managing them. In other words, buy or sell from each holding to get back to the desired percentage amount invested in each fund. For a tutorial about How to Amass $787,355 with a Lazy Investment portfolio, click on the link.  

For DIY investors, set a simple asset allocation to grow your wealth over time. There are even studies that suggest that a well-diversified asset allocation, rebalanced every year, will not only reduce volatility but increase your returns a small amount.

If you are not a DIY investor and want to pay a small fee for investment management, you might consider examining a robo-advisor comparison chart for help choosing a digital investment manager. 

For those asset allocators out there, what is your asset allocation and why?

A version of this article was previously published.

    15 Comments

  1. Simple is always better Barb! Ted Aronson, the famous money manager, manages investments that run to billions of dollars for his clients. Yet, when it comes to his own family’s wealth, he puts them all under an indexed portfolio!

    Something to think about!

    Moneycone

    January 9, 2012

  2. @Money and Joana- Many portfolio managers use a basic asset allocation model with index funds and etfs. Science is behind this approach!

    Barb

    January 9, 2012

  3. Yes, asset allocation is such an important lesson. It is so easy to do the simulations and think this can’t be easier, but then when all of YOUR investments plummet, there’s not ecstasy on your face. Going with a good solid strategy including proper asset allocation is definitely better.

    Roshawn @ Watson Inc

    January 9, 2012

  4. Good timing! I generally look at my asset allocation annually in Deceember and make my changes for the new year.

    krantcents

    January 9, 2012

  5. @Roshawn, Although is sounds really easy in theory, even I have a difficult time sometimes making the changes. Fear and greed are powerful emotions!
    @Krantcents-That’s a great time, it’s hard to forget the beginning of the year.

    Barb

    January 9, 2012

  6. Asset allocation can make a big difference in what one has for retirement or other major life needs. It’s important to make and save money first, of course. But ignoring asset allocation is like a football player rambling to the goal like without gripping the football tightly. Not paying attention to the details can cause a fumble, which is what having the wrong asset allocation can do. Best to do what’s right for each of us at different stages in our lives.

    Squirrelers

    January 10, 2012

  7. @Squirrelers, How aptly put. In fact, I’ve read that 90% of ones returns can be attributed to their asset allocation.

    Barb

    January 10, 2012

  8. There are mutual funds that allow you to setup your desired allocation once and have it automatically re-balanced each quarter. I’ve never used them because I enjoy controlling the re-balance, but they are available.

    Marie at FamilyMoneyValues

    January 10, 2012

  9. Marie, You really need to watch out for “asset allocation funds,” as they all vary and rebalance in differing ways with various allocation. They frequently sport higher fees than vanilla index or ETFs, but thanks for bringing up the topic.

    Barb

    January 10, 2012

  10. Having the asset allocation is great but not keeping up with rebalancing is what can really get you in trouble. There are a few studies out that all show 100% equities are inevitable without rebalacing.

    JP @ Novel Investor

    January 10, 2012

  11. Hi JP, Actually, you will not end up with 100% equities if you don’t rebalance if you started out with some percent in fixed or other asset classes. But, if stocks continue their historical outperformance, they will dominate your portfolio without rebalancing.

    Barb

    January 11, 2012

  12. Hi Dan, Well, I guess that is better than nothing. But, for anyone with a 401 (K) or 403 (B), it’s best to educate oneself a bit about basic investing.

    Barb

    January 12, 2012

  13. Okay, I love it when you said “If you can’t get enough asset allocation, here’s more.” Hahahaha! Love it. Enthusiasm is contagious:).

    Amanda L Grossman

    January 12, 2012

  14. Barb,

    What type of asset allocation between equities and fixed income would you recommend in 2012 for someone who is mid-career, and a moderate risk taker?

    Regards,

    Sam

    Financial Samurai

    January 14, 2012

  15. Sam, I really like to help others become wealthy, and your question is superb. There’s just one problem, it’s a really tough one! I don’t have enough information to give a really helpful answer for one’s individual situation. I’ll share a personal story instead. When I was mid career, I was about 65% equities and 35% fixed. And I consider myself a moderate risk taker. I’d also check out the Lazy portfolios link above for some great sample asset allocation. And, my 20 Minute Guide to Investing (top right, free with Wealth Tips sign up)also has some ideas.

    Barb

    January 14, 2012

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