Over the last few weeks we’ve covered the different account types (Taxable Accounts, Tax-Advantaged Accounts) along with the importance of Asset Location. This week we’ll follow-up with the benefits of an appropriate asset allocation and the value-add it brings to an overall financial plan.
What do we mean by asset allocation? Asset allocation is an investment strategy that aims to balance risk and reward by positioning your portfolio’s assets according to your goals, risk tolerance, and investment horizon.
The four main asset classes – equities, fixed-income, cash and equivalents, and alternative investments – have different levels of risk and return, so each will behave differently over time.
When selecting an appropriate asset allocation, the primary objective is to select the proper weight for each broad asset class rather than selecting the individual investments within each. In other words, the selection of individual securities is secondary to the way that assets are allocated from a high level in stocks, bonds, cash, and alternative investments, which will be the key determinants of your investment results.
There is widespread debate about the importance of asset allocation when building a portfolio. One study shows that asset allocation explains about 94% of portfolio performance (Brinson, Hood, and Beebower – 1986). Another study shows that asset allocation really only explains about 50% of portfolio performance, and the other 50% is attributable to active management decisions (Xiong, Ibbotson, Idzorek, and Chen – 2010). Although the research may differ, it’s important to understand that asset allocation plays a major role in the performance of your portfolio (even 50% would be considered a meaningful driver of returns).
Asset allocation is an ongoing process that must be monitored constantly. There are two main strategies used when setting your asset allocation:
Strategic Asset Allocation involves setting your long-term allocation target and then periodically rebalancing the portfolio to stay consistent within the target weights. This is often referred to as a buy-and-hold strategy. However, over time, the allocations will begin to shift due to market movements. One asset class may be performing better than another, which will shift the weights within the portfolio. When this happens, it is important to rebalance the allocations back to the original targets. Rebalancing keeps the portfolio in-line with your overall risk and return goals.
The two primary rebalancing strategies are calendar and threshold. Calendar rebalancing is the less complicated of the two as you only rebalance the portfolio on a set date, such as the first day of every month. Threshold rebalancing is slightly more complex as it involves creating “bands” around each asset class. When an asset class crosses past it’s allowable band, the portfolio is reset to the original target asset allocation.
Let’s use a quick example to illustrate these rebalancing techniques. Assume you have a portfolio that has a target asset allocation of 40% equities, 40% fixed income, 10% cash, and 10% alternative investments. What happens if the stock market goes up and bonds go down after the first two weeks? Your new allocation might be 45% equities, 35% fixed income, 12% alternative investments, and 8% cash (equities went up in value, fixed income went down in value).
If you had a calendar rebalancing strategy for the first day of each month, you would keep waiting until the month is over to rebalance the portfolio. On the first day of the next month the allocations would all be reset to the original 40/40/10/10 by making the appropriate buy and sell transactions. However, if you have a threshold rebalancing strategy with a band of 4% you would rebalance today. Since both equities and fixed income have moved past the 4% band threshold (35% and 45% are each 5% away from the original 40%) you need to make the appropriate buy and sell transactions to achieve the original 40/40/10/10 allocation.
Tactical Asset Allocation is similar to strategic asset allocation, but it allows for a wider range of each asset class. This gives you minimum and maximum allowable percentages that permit you to take advantage of market conditions. For example, you can have a range for equities of 35% – 50% of the overall portfolio. Setting this range allows you to pursue a minor amount of active management and market timing. When you believe equities will be doing well, you could shift the weight to the top end of 50%. If equities were expected to perform poorly, you could shift the weight to the bottom end of 35%. The overall equity weight must always fall between 35% – 50%, but you are allowed some wiggle room in the middle.
As explained above, asset allocation can vary between passive buy-and-hold or slightly active / tactical strategies. The appropriate overall allocation for an investor depends on their risk tolerance, return objectives, and market beliefs. It’s important to work with your financial planner to ensure that your asset allocation is appropriate based on all of these variables.
Ben Webster, CFP® and Derek Prusa, CFA, CFP®
Co-Founders and Owners of Aspire Wealth
The Advantages of Tax-Advantaged Accounts
