Build your Perfect Portfolio to Optimize Returns and Minimize Risk
"Based on my own personal experience, rarely do more than three or four variables really count. Everything else is noise." -- Marty Whitman, Former Manager of $3.2 billion Third Avenue Value Fund
Growing up in Toronto during the late 80s and early 90s, enjoying the spoils of a perennial contender and ultimately World Series Champions in the Toronto Blue Jays, I was a pretty rabid baseball fan. My passion went beyond the clichéd aspects of the storied game, the timelessness nature of baseball, the strategy behind a hit and run play, or the awesome power of a home run crushed to right center field. While these elements of baseball kept me fixated on the slowly evolving, yet deliberate action on the diamond, it was my fascination with what it took to construct a consistently contending team that graduated me from your average fan to armchair General Manager.
When constructing a world champion baseball team, you have to have the right balance of offensive and defensive players, ace starting pitchers, long relievers to get you through the middle innings and that menacing closer with “nasty stuff” to intimidate your opponents best hitters into submission in the last inning of a close game. It would not be good enough to stack your line-up with power hitters, you must have speedy lead off hitters who can draw walks and essentially find a way on base to “set the table” for your power hitters to score with one swing of a bat. You want solid pitching and defense so when your hitters slump you can still win games by holding the other team off the scoreboard. You’ll also want a good blend of wily veteran players to help shape your star players and emerging rookies into players that are disciplined enough to win. You get the idea, building a winning team in baseball requires thinking about the bigger picture and carefully constructing your team with the right blend of players that will complement one another, bring a diverse set of skills and provide the right chemistry to maximize your chances of winning in the era of baseball you are trying to compete in.
It’s no different with investing. Putting all of your money in high growth stocks and nothing else, like building a line-up solely of home run hitters that can’t get on base, can’t play defense or can’t run the bases, will set you up for failure over the long run. Just like baseball where a one-dimensional team of home run hitters won’t be able to manufacture runs when these power hitters are striking out, your investment portfolio of strictly high growth stock will show negative returns when the stock market cools. Or, concentrating in domestic markets with no exposure to emerging international economies can leave you crying foul when your domestic economy cools. Baseball General Managers don’t limit themselves to finding talent in just the US or Canada, they look to other baseball loving countries to find the next star they can add to their roster. When it comes to investing, you too should not limit yourself to finding your next star investment in the US or Canada alone.
But, with the myriad of options available for investing your hard-earned money, how do you decide which to include in your portfolio and how much in each type? Pick up any financial magazine or business newspaper section and you’ll be overloaded with slick advertisements from the more mundane investment product such as bonds, GICs and mutual funds to the more exotic financial products, each clamoring for your investment money.
To construct your perfect investment portfolio, one that’s going to optimize your rewards over the long run, while protecting you against the risks that are associated with investing, it’s imperative you engage in one of the least sexy yet most important aspects of successful investing – asset allocation.
In this post I define asset allocation, explain its importance, outline the main asset classes, how to determine your investment portfolio asset allocation mix and the steps for doing it.
Asset Allocation Definition
Asset allocation is a crucial function of any sound investing approach that determines how best to allocate the money in your portfolio across the various classes of assets (e.g., stocks, bonds, cash, real estate and others) so that you optimize your investment return in consideration of your stage in life and tolerance for risk. In other words, asset allocation provides you with a roadmap that helps you get the most out of your investing without causing you sleepless nights.
Why Asset Allocation?
With the myriad of domestic and international investment options for your well-earned capital, from fixed income securities such as bonds, to small, mid or large cap equities, real estate or mutual and exchange traded funds, you can get dizzy thinking about how best to allocate your capital to optimize returns and minimize risk.
Most uniformed investors detour this important step and end up investing exclusively in mutual funds out of fear of making a mistake or just plain laziness – I myself was guilty of this early in my investor life and paid for it with underwhelming returns and high fees.
So why bother with asset allocation?
It is one of the most important determinant of returns. Although most investors spend their time figuring out what stock to buy – Apple versus Microsoft; the more important decision is determining what assets you should hold, what percentage you should allocate towards each, and how you should diversify within each asset class. Diversifying within each asset class means, determining how much to invest in domestic vs. international markets, what industries to invest in, and so on. Many studies have been conducted on asset allocation, finding that it explains almost 100% of the level of investor returns.
Diversify risk. Asset allocation helps reduce the risk inherent in holding assets or stocks in your portfolio that share too many of the same characteristics, causing similar performance in good and bad times. Theoretically, if one asset class declines, another will likely increase, offsetting losses and stabilizing your returns. Harry Markowitz, winner of 1990 Nobel Prize for economics and often regarded as founder of modern portfolio theory put it best:
Maximize returns. If you don't include enough risky investments in your portfolio, you may not earn a large enough return to meet your goals, whether that’s putting your kids through university or ensuring a full retirement.
Cash and equivalents
The cash part of this is easy to understand. We are talking money, green back, dough, moolah, bacon, bread, cake, shekels, or quid for my British friends. It’s the “equivalents” component of this asset class that’s a little harder to understand. Cash equivalents are places to park money you will need in emergencies or in the short term, to eek out a small return. When I say small return, I’m not exaggerating. Cash equivalents struggle to outpace inflation over time, but the good news is they carry little risk. So, when you need your cash it’s very easy to liquidate with the value preserved, and you get the bonus of a very small increase. Options for cash equivalents can include money markets, certificates of deposit, and guaranteed investment certificates.
How much cash (or equivalents) should I have?
As an emergency fund, in case of job loss, medical issue or other unforeseen events; I believe having enough cash on hand to cover three to six months worth of expenses will allow most people to sleep well at night.
Putting aside your emergency fund, what about having cash on the sidelines in your investment portfolio. I personally only have cash in my investment portfolio for the sole purpose of deploying it to purchase stocks when the market declines and good companies can be found in the bargain bin. The amount of cash I hold in my account is directly proportional to the stage of the market cycle at the time. If the market is overheated and company valuations are much higher than fair value, I will lock in some gains by selling some shares in over valued stocks and hold more cash in my portfolio than periods of depressed valuations. When the next market crash happens and Starbucks has lost 40% of its value, I want some cash on the sidelines to be able to scoop up some discounted shares of a still fundamentally solid company.
I don’t think there is a perfect cash allocation percentage for elevated versus depressed market cycles. If the current stock market is way too frothy (i.e., where stock valuations are massively inflated) I target between 10% and 20% cash holdings in my investment portfolio. In times of recession, once I’ve found the best value for my investment dollars (both in terms of the stock being undervalued and the company having solid fundamentals), I would expect to be fully invested. This means having all my cash invested in the stock market, or the other assets that make up my investment portfolio. After a major correction, when everyone is running from the stock market, is the best time to go on a buying spree. This is when investment careers are made.
The one exception to my philosophy is for those who are near or in retirement. At this stage, cash preservation is the name of the game and you want to have enough of a cushion to not feel you need to quickly liquidate solid stocks that are undervalued only because of macro conditions out of their control.
Prepare to fight to keep your eyes open as I’m now going to explain more about bonds. As far as bonds are concerned, they are the broccoli of asset types. They ain’t mouth watering but bonds are good for you. Make sure you get enough of them as part of your investing diet.
Bonds are basically IOUs between the borrowers, corporations and governments, and the lenders – bondholders. Holding bonds in your portfolio is advantageous because they offer a way to diversify your portfolio and protect yourself from inevitable market volatility, they provide income, and have some (albeit small) capital appreciation potential. Bonds are the fixed income cornerstone of your portfolio.
There are many different types of bonds, including corporate bonds, federal, provincial, state or municipal bonds, government agency bonds, and international bonds.
Because I don’t know much about bonds and I don’t want to spend my time vetting each individual issuer only for a small return, I prefer to use bond funds. These bond funds help diversify within the bond market and offer a convenient way to add this essential element to your investment portfolio. If you are interested in going deeper on bonds, I’d suggest checking out this guide on how to invest in bonds for beginners from the Motley Fool.
Check out the following reputable resources for some suggestions on good bond funds to consider:
The balance: 8 Best Bond Funds to Buy for the Long Term
ETFdb.com: Bond ETF List
Stocks are the cornerstone of a growing portfolio. They are your star quarterback. They are the leading man or woman in a movie. They are unquestionably the sexiest of all assets.
Over the long term, investing in stocks is the best way to ensure that your portfolio withstands inflation and sets you up well for a comfortable and fulfilling retirement. History has shown us that stocks are the highest performing asset class as compared to all other types of financial securities over the long run. As measured by the S&P 500 index, the average annual total return, including dividends, since inception in 1926 has been 9.8%. This does not mean you can count on 9.8% return every year. If it only where that easy. Stocks go through rough patches as they did during the great depression and more recently with the great recession or the Coronavirus pandemic. Over the long run stocks are proven performers and a must for your portfolio.
I’m sure I did not have to convince you to own stocks. However, there are two important questions most investors don’t ask, that they should – i) how many stocks should I own, and ii) how should I allocate my capital within the equity asset class to optimize return and minimize risk. With so much on the line you don’t want to be random about your stock portfolio construction.
It’s not possible to ascribe a fixed number of stocks to own. There are too many variables, and you have to do what’s comfortable for you. I can tell you there is such a thing as having too few stocks and too many stocks in your portfolio. The following are considerations I recommend for determining how many stocks you should have in your portfolio:
Own as many stocks where you have an edge for understanding if the company is a good long-term investment. It’s not possible to have an edge in an infinite number of stocks, there is not enough time to be an expert in thousands of companies. 12 to 24 seems reasonable for most informed investors. If you are pushing 30 stocks or more, you probably aren’t being totally honest with yourself in terms of the time and capacity you have for analyzing and monitoring a set of stocks. Where you don’t have a knowledge edge, buy Exchange Traded Funds (ETFs) to achieve the required diversification for your investment portfolio. For example, I don’t know much about emerging markets, so I invested in an emerging market ETF.
Own enough stocks in your portfolio to spread your risk around. If you only own one or two stocks, a steep percentage decline in one of those stocks will mean a significant percentage decline in your net worth. To minimize the risk of investing in the stock market, I’d suggest a minimum of 12 to 14, but consider the words of a whiz who crunched the numbers to provide some guidance:
Prioritize quality over quantity. Don’t feel like you need to rush out on day 1 of the start of, or re-birth of, your investing career and have your portfolio fully invested in 20 or so stocks. You can build up to the right number of stocks over time, taking the time you need to make the right decision of which markets, industries, and companies you should invest in. You don’t want to leave your undiversified portfolio to sit unattended to for too long. But focus on finding companies with solid growth prospects that are well managed, rather than just getting to the right number of stocks as quickly as possible. For more guidance on how to invest wisely, check out the Wealthy Owl’s checklist for selecting winning stocks.
How should I allocate capital within my stock portfolio?
What are the different ways you can diversify your stock portfolio so that when certain markets or industries are zigging, others will zag? I think there are four main diversification variables that should be considered in constructing your own stock portfolio:
Geographical diversification is a common way to reduce risk by avoiding being overly concentrated in a specific region or country. It involves including stocks from different geographies in your portfolio.
Economic cycles are often experienced at different points of time in different geographic markets. For example, the U.S. stock market may be in decline due to a recession while China is experiencing an economic boom. By practicing geographical diversification as part of your investing strategy you will reduce the risks related to macro economic factors. In other words, losses in one geography may be counteracted by stock market gains in another part of the world.
My primary geographic concentration is the US and Canada (75% of my portfolio, with a heavier US allocation), with exposure to international markets via both developed (UK, Switzerland, Japan, etc.) and emerging (China, India) countries.
I rely heavily on ETFs for getting exposure to foreign markets as I do not feel I have enough familiarity with these different geographies to be able to pick individual companies. There are exceptions. For example, I’ve used my understanding of the technology industry to select individual hi-tech stocks in China.
With over 11 major sectors making up the stock market, including telecom, energy, financial services, health care, industrials, consumer, information technology, retail and materials, there are several options to achieve diversification. Just because you can invest in each of the 11 different sectors for the purposes of diversification doesn’t mean you should. Some of these sectors carry with them a disproportionate amount of risk. For example, I avoid the materials sector altogether because of its volatility. My decision to avoid the energy sector is based on my personal belief that over the long run sustainable energy sources will replace more traditional sources, bringing new industry titans that are difficult to identify at this stage.
I think it’s reasonable to over allocate slightly to industries you understand very well. It’s a good idea to exploit your edge when it comes to growing your wealth. But don’t fall prey to false confidence. Just because you know the industry, avoid being overconfident or having tunnel vision where you don’t see broader secular trends affecting your favorite industry.
There are three main ways to segment stocks according to their size:
Large cap stocks: Market capitalization of $5 billion or more. Amazon, Microsoft, Berkshire Hathaway, McDonalds, and Apple are all recognizable large cap stocks. These stocks are generally less risky due to their track record of consistent revenue and earnings growth. A somewhat unique feature of large cap stocks is that they offer diversification through the different products they have and the many geographies they operate in.
Mid cap stocks: Market capitalization between $1 billion and $5 billion. These stocks have higher growth potential but more risk than large cap stocks.
Small cap stocks: Market capitalization below $1 billion. A more extreme version of mid cap stocks in terms of the higher growth prospects and risk. Fishing in the small cap pond is like scouting for baseball players in the minor leagues. You want to find the diamond in the rough talent that no one else knows about, and that have the potential to be a ten bagger (Wall street parlance for a stock which gives a return of more than 1000%+).
There are lots of good ETFs that specialize in small and mid cap stocks, a good route to go as it is quite difficult to choose the next Google from the thousands of wannabees in the small cap world. I favor the Vanguard Small-Cap Value ETF (VBR).
You will want to be more heavily weighted in large cap (I target at least 60% of my portfolio to be in large cap), especially as you advance in age, to mitigate the risk that comes with small cap stocks. Beware that the smaller the company, the greater the likelihood of volatility.
The two most well-known investing strategies, value and growth, offer another dimension to further diversify your stock portfolio. What is value investing and growth investing?
Value investing involves looking for companies that have solid fundamentals but that are trading at a discount relative to peers due to some market perception issue. Sometimes Wall Street, with all the emotions that play into investing, is not valuing a company appropriately. For excellent companies, this will only be temporary. Warren Buffet the “Oracle of Omaha” perfected the art of value investing in his astounding 50-year service as the Chairman and CEO of Berkshire Hathaway. A position he holds today at the young age of 89 years old. Warren Buffet learned from the father of value investing, another investing legend Benjamin Graham. Yes, Ben Graham was the teacher of value investing; but his star pupil Warren Buffet has really solidified himself as the legend when it comes to putting the theory of value investing into practice. His legendary status is crowned by his back and forth battle with his own mentee Bill Gates over the years for the title of the world’s wealthiest person.
Growth investing is about finding companies with faster than average growth. Higher risk than value investing, but higher reward. The guru of growth investing is Peter Lynch, another legendary investor who managed a Fidelity mutual fund to an impressive annualized return of 29% for 13 years before retiring. Good to go out on top.
Who should we be like as investors, Warren or Peter? Life is full of such head to head competitions. Tim Horton’s or Starbucks? The Beatles or the Stones? Coke or Pepsi? Perhaps one of the biggest perceived “either/or” decisions in the investing world, do we really need to choose between growth or value? There’s really no reason an investor needs to make this false choice. In fact, in his “What Works on Wall Street” book, American investor James O’Shaughnessy back-tested these two different investment strategies and found that while both strategies handily beat the broader market over time, an investor could build an even higher performing portfolio by purchasing some stocks picked with the value model and some picked using the growth model.
Another investing style, sort of a hybrid of the two with a twist (or more accurately a yield), is dividend growth investing. This investing strategy involves buying stock in companies that pay out a portion of their earning to shareholders in the form of dividends. While it may be slightly controversial to distinguish dividend growth investing as its own style, I think it’s worth mentioning. Companies that pay a high dividend outperform companies with low to no dividends (Source: Siegel, Jeremy, Future for Investors). To learn more about dividend growth investing check out the Wealthy Owl’s definitive guide.
A note on timing: Dollar cost averaging as an aspect of diversification
An often-overlooked method of diversification is related to timing. I’m NOT recommending trying to time the market, that would be foolhardy. You should however recognize that the market runs through different cycles. There are times when market values are elevated, and times when they are depressed. It makes sense then that we diversify our stock purchases at different stages of a market cycle. For example, rather than investing all the cash we have on the sidelines during depressed markets, we should use dollar cost averaging to our advantage. Dollar cost averaging (DCA) is a strategy where investors divide the total amount to be invested across periodic purchases of a stock or set of stocks. For example, rather than investing $8,000 into my favorite stock all at once, I would invest $2,000 every week for the next four weeks. This helps reduce the impact of volatility on the overall purchase price. This is especially useful in times when prices are falling dramatically, it can help remove emotion from your investing during a time of high volatility.
Real estate has created a significant amount of wealth for its owners over the years. As Mark Twain once said:
“Buy land, they’re not making it anymore.”
In addition to providing diversification, investing in real estate also offers potentially higher returns, stability, the use of financing leverage to maximize returns and a steady flow of income over time from rent.
It’s the combination of rental income, leverage and appreciation that offer investors a different asset class with the potential for high returns.
While there is not really a reliable way to assess the returns of real estate investing vs. the stock market, the Motley Fool did an interesting comparison of the S&P 500 stock index and the Vanguard Real Estate mutual fund (chosen because it represents a good benchmark index of real estate trusts). It’s a limited timeframe, relative to our look at stock market performance, but it show us the potential for high returns.
Source: Millionacres, A Motely Fool company, https://www.fool.com/millionacres/real-estate-investing/articles/real-estate-vs-stocks-which-has-better-historical-returns/
Real estate investing has its disadvantages. For example, real estate investing typically requires a lot of money upfront and burdens investors with ongoing maintenance and management. There are some alternative ways to invest in real estate, outside of buying a property and renting it out to tenants. Let’s review some of these as ways of getting exposure to some of the benefits of real estate investing, without the downside.
Real Estate Investment Trusts (REITS)
REITs are publicly trade companies that own real estate. They typically own large-scale properties like commercial buildings, shopping malls, hotels, and apartments. There are other specialty REITs that allow you to play certain trends, like how data center REITs and cell tower REITs are benefitting from cloud computing and 5G connectivity. REITs are focused on distributing income to their shareholders from earnings. In fact, to qualify for the government provided REIT status they must distribute most of their income to shareholders.
Rather than select individual REITs I have chosen to invest in REIT ETFs. In recognition of my lack of knowledge of this space and therefore inability to accurately assess individual REITs I prefer to benefit from real estate income through the diversification that ETFs offer. The REIT ETFs I own include iShares Global Real Estate Index (CGR) and the Canadian BMO Equal Weight REITs Index ETF (ZRE).
Real Estate Crowdfunding
Commercial and large residential real estate projects, while an attractive investment, have been elusive for the average investor. A new form of real estate investing, real estate crowdfunding changes this. Real estate crowdfunding is the pooling of capital from multiple investors for investment in real estate projects. From an investor perspective it allows individuals to buy a portion of commercial and large residential real estate projects that historically have only been available to the ultra rich or large institutions. Most real estate investment opportunities like this have a minimum investment requirement of $100,000 and up. I have seen real estate crowdfunding projects with minimum funding requirements as low as $500. Fundrise and CrowdStreet are the most well-known real estate crowdfunding platforms. For the most comprehensive guide to this intriguing real estate investing option check out the Financial Samurai’s Guide to Real Estate Crowdfunding.
Other Asset Classes
For the purpose of completeness, there are some additional asset classes to consider. These include commodities (e.g., gold, oil, metals, and foods) and collectibles (e.g., fine art, coins, baseball cards, stamps). Neither are asset classes that interest me, nor ones I would recommend to the average investor, especially collectibles.
How to determine your investment portfolio asset allocation mix?
Asset allocation is about making decisions now about the construction of your investment portfolio that will determine what your lifestyle will be like today and in retirement. For the purposes of this post we will focus on preparing for retirement. If your managing multiple portfolios for different life goals beyond a comfortable retirement, such as buying your dream home or starting your own business, you will also need to consider when you will need the money.
Determining your retirement portfolio asset allocation mix depends on two main factors – stage of life and your risk tolerance. There are other factors such as investment objectives and experience, dependents, and marital status. But I’ll focus on the two most important.
Stage of life
Your asset allocation strategy should change as you go through the different stages of life. It’s not something you do once in life, never to revisit. Life happens, whether it’s health issues, job changes or loss, marriage, divorce or promotion. Certain asset allocation strategies are more appropriate than others at different stages of your life. You will go through different stages of your work life from the beginning of your career through retirement that necessitate an appropriate strategy to achieve your goals. Here are the main stages that most of us will go through in our career and the asset allocation strategies you should consider for each.
Early Years: “Started from the bottom”
We all start at the bottom when we begin our career. It might be working for yourself, as a professional or at the bottom of the corporate ladder. The goal is that there is significant growth at the end of your career from where you start, in terms of salary, experience, skills, expertise, sense of purpose and relationships. We all want to be able to say like Drake:
If I could go back in time and share some wisdom with my 16 year old self, beyond telling myself to not worry so much what people think of me, I would espouse the importance of getting started with investing and asset allocation. From the time of your first paycheck, from babysitting or working at McDonald’s, you should begin your investing and asset allocation journey. While I can’t go back in time, I can pass this lesson along to my two boys at the right age. The power of compounding and starting early are just to significant to ignore.
The other advantage to start investing early in life is that it provides a long runway of time to recover from market crashes, affording early in life investors to take more risk in pursuit of growth.
While earnings are typically low in this stage, along with the debt you may be carrying, you should try to save and invest as much as you can to a tax protected retirement account. Take advantage of employer 401(k) or an RRSP match program, where companies match their employee retirement account contributions dollar for dollar up to a fixed amount. Don’t leave free money on the table if you can avoid it.
Middle Years: Climbing the ladder
Typically occurring in your 30s and 40s, the middle years are when you are ascending in your career. Climbing the corporate ladder. As you progress in your career, your income will increase, but so will your expenses as your financial responsibilities increase as a result of marriage and children.
Growth should continue to be a focus of your portfolio, with some initial risk mitigation and capital preservation being introduced. This means increasing the amount of fixed income investments, such as bonds, as compared to your early investing years. You still have a lot of time for market recoveries when the market goes through a correction or crash. If a crash occurs causing substantial discounts on high quality, fundamentally sound companies, you should consider dipping into your cash and fixed income investment to go on a buying spree. I wouldn’t be reckless; I would use dollar cost averaging. There are only so many of these crashes that will occur in your investing lifetime so take advantage when you have enough time to benefit from the recovery.
Practical considerations during this stage include establishing an emergency fund should you or your spouse lose their job and investing in tax protected child education accounts in preparation for covering your children’s college or university expenses.
Later Years: Maxing out
During the later stages of your career (between 50 and 65 years old), your earning power is likely to be at its highest. With lower expenses and mortgage payments, as your kids become independent and you pay off most of your house, you will have more of your income to invest than at any prior stage of your career. Bummer that it took so long.
Your accounts should become a little more conservative in the stage just before retirement. This involves moving some funds out of equities and into bonds and cash equivalents. If you have not been investing in dividend paying companies, consider transitioning more of your capital into dividend payers to grow your income. Living more off asset income, rather than depleting your capital as a draw down in your retirement, can help reduce the common retirement stressor of running out of money. It also enables you to leave a larger financial legacy to your family or most important cause.
Continue to invest in stocks, their return potential makes them a staple of your portfolio, even at these later stages of your career. Reconsider your investments in high risk stocks at this stage if your style has traditionally been growth. These remaining years of your career are much too close to retirement to take risk. You don’t have the time you used to for recovering from riskier investments that go bad.
Retirement: Now what
The last thing you want to have to ask yourself on the first day of your retirement is, what do I do now? Hopefully, you’ve planned how you will spend your retirement, and therefore are prepared for the lifestyle you will now need to support.
With a focus on maintaining your pre-retirement lifestyle, your asset allocation strategy should shift from wealth creation to preservation and income at this stage.
Being honest with yourself about your risk tolerance is both hard and critically important. When the market collapses, will you be able to stomach the declines without getting nervous and selling out of your equity position? This is the difference between suffering massive realized losses that could take a decade or more to recover from and realizing the gain of an inevitable upturn. The average decline of a bear market is 28%, the average gain of a bull market is over 128% (Source: Investopedia, https://www.investopedia.com/articles/investing/021116/3-reasons-not-sell-after-market-downturn.asp). If you sell in a downturn, not only will you realize a loss, but you’ll deprive yourself of the next bull market that will only recover the losses and extend the gains of the previous market cycle.
It’s really hard to predict how you will react when you lose 30-40% of value off your investment portfolio, in a couple of weeks. All investors have “loss aversion” instincts. It’s a matter of whether you can control these basic instincts, and the best we have for predicting your emotional behavior during such a market crisis is assessing your risk tolerance as honestly as you can.
While it’s a subjective process, there are some methods:
Asset Allocation Strategies
How do we combine these factors to determine the best asset allocation strategy for ourselves? It is a personal decision that should be made with real honesty, and one that you should revisit as circumstances change. The asset allocation model I’ve put together uses your risk tolerance assessment and your career stage to recommend four distinct allocation strategies:
Growth: Maximize savings and aggressive pursuit of portfolio appreciation
Balanced: Combination of growth, income, and some initial risk mitigation
Stable Income: Emphasize income through fixed income investments (e.g., bonds) and dividend stocks
Capital Preservation: Keep principal stable and generate steady income
Use your risk tolerance as the default setting for selecting your allocation strategy. For example, if you are in the early or middle years of your career but you have exceptionally low risk tolerance, skip ahead to the stable income strategy, regardless of your career stage. You will likely pay for this in terms of lower portfolio growth rates, but you cannot put a price on sleeping well at night regardless of what’s happening in the stock market. Just make sure you don’t over index on capital preservation prior to retirement to avoid losing your portfolio’s “real value” that comes with not keeping up with inflation. A portfolio without stocks can lead to you suffering a real value loss to your money.
Steps for allocating your assets
There are five steps for determining and realizing the best asset allocation strategy for you. This process is to be done on a recurring basis:
Set your objectives: What are your financial objectives in the short, mid and long term.
Choose asset classes and allocation into each: Much like making a recipe for the perfect dessert, this step is about determining your ingredients (asset classes) and determining how much of each ingredient you should include (allocation).
Diversify within each asset class: Take diversification to the next level of granularity. You need to also decide how you will allocate your capital within each asset class. For example, what bonds will you hold? Which stocks?
Monitor and act: Asset allocation is an ongoing process. At least annually you should be assessing how your portfolio is performing to the relevant benchmarks. If a stock does really well and becomes an outsized portion of your total portfolio, take action and reduce your position. This is a good problem to have. You don’t want to suffer the downside risk to your overall portfolio if that stock crashes years after a great run. It can happen to the best of stocks. Ask long time General Electric (GE) shareholders, or for those of you can remember – Nortel. Examine your life circumstances and adjust your portfolio if appropriate after major life changes. Slowly start to change your allocation strategy when you transition into a new phase of your career.
One of the most important success factors for wealth creation, determining your asset allocation strategy can seem tedious, but data and history shows it’s table stakes. Don’t be distracted by the next can’t lose IPO or hot tech stock, make sure you are spending the time necessary to get your asset allocation mix right.