In this podcast (below), I will answer the question: What general types of investments should I consider? I will discuss stocks, bonds, ETFs, mutual funds, gold, commodities, real estate, REITs, and more.
Asset allocation is simply splitting an investment portfolio among broad categories of investments. Those broad categories are typically US stocks, international stocks, fixed income (bonds and treasuries) and short-term reserves (cash, money market funds, short-term CDs). Some advisers add “alternative investments” (real estate, commodities, partnerships, etc.) as a separate broad category.
The asset allocation that works best for you at any given point in your life will depend largely on your time horizon (when you need the money) and your ability to tolerate risk (willingness to hold onto investments even if they go down in value).
These broad categories have differing degrees of correlation, or the extent to which their movements are related or similar. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, one can limit their losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Correlation can change over time, during the 2008-2009 financial crisis all asset classes, except for high-quality bonds, suffered losses together. Since 1972, there have been four periods when most of the asset classes all had big losses.
Strategic allocation is a long-term allocation that balances the desired returns and risk tolerance. Because different investment classes perform differently, the investor may “rebalance” the portfolio periodically by selling the better performing investment class and buying the lesser performing class to restore the target allocation. A strategic allocation only changes when there are significant changes in circumstances or goals.
Numerous studies have confirmed that around 90% of both portfolio performance and variance in quarterly returns are attributable to the combination of overall market movement and strategic asset allocation. These findings are part of the popularity of index funds, which track a particular market without trying to pick winners and losers. Once an asset allocation is determined, using index funds for each major asset class is an easy and cost-efficient way of implementing the allocation.
Tactical allocation is an approach that includes different factors such as industry sectors and company market value and will shift assets based on market trends in an effort to outperform the overall market. Tactical asset allocation places bigger bets on certain areas of a market. This can be considered as a form of market timing, and consistently getting that timing right is nearly impossible and more expensive than simply indexing the market. The higher cost, of course, is why this approach remains prominent despite its mixed results. There are certainly security pickers who beat the market but identifying them before their hot streak begins is very hard and most security pickers who beat the market return to average performance in later periods.
Selecting the actual vehicles is less important to the portfolio outcome than determining the desired allocation. Investors can do themselves a huge favor by first deciding how to slice the pie with a strategic asset allocation.
AIO Financial is an independent comprehensive fee only financial planning firm that works with individuals