The importance of asset allocation
Asset allocation is an investing concept that refers to how much you have allocated to different asset classes.
In theory, there could be many asset classes you follow, including stocks (the stock market), fixed income (bonds and cash), real estate, commodities, art, vintage cars, bitcoin, jewelry, etc.
For the sake of simplicity, we limit our discussion to equities and fixed income securities.
The asset allocation you choose is extremely important to the future performance of your investments. A classic 1986 study in the financial industry (by Brinson, Singer and Beebower) estimated that 91.5% of a portfolio’s performance is based on the asset allocation decision, with 4.6% on the stock selection, 1.8% on market timing and 2.1% on other factors. A 2012 study by Daniel Wallick and colleagues at Vanguard looked at the 1986 study and found that asset allocation drove 88% of a diversified portfolio’s return.
Clearly then, deciding which asset allocation you use is worthy of your time.
You may have heard of the rule of thumb that recommends you deduct your age from 100 to get the percentage of shares you should have. This would mean that a 20-year-old investor should hold 80% stock and a 60-year-old investor should hold 40% stock. I don’t agree with this rule.
If we had a crystal ball – and could predict the performance of the stock market for the next 25 years – we could choose our asset allocation without any risk. If we knew the stock market would be strong, we would pick a high percentage of stocks. If we knew the stock market would be weak, we would choose a low percentage of stocks. Lots of people try, but I don’t know anyone who can accurately predict the future.
Someone recently predicted that the stock market won’t do anything for the next 10 years. He described it as a “lost decade”, which happened in Japan between 1991 and 2001. In my opinion, this person has the same chance of being right as assuming that the stock market (S&P 500) will return 17% (including dividends) per year on average over the last 10 years (2012-2021). If you expect future returns to be rosy, remember that the S&P 500 only returned an average of 1% per year during the decade from 2000 to 2009. Negative returns in 2000, 2001, 2002 and 2008 wiped out most of the gains of the entire decade.
When choosing your asset allocation, you need to consider the uncertainty of future returns. Many financial firms recommend an asset allocation of 60% equities and 40% fixed income for many of their clients. Others recommend 50% equities and 50% fixed income, or a lower percentage of equities.
The asset allocation you choose should be related to your goals, risk tolerance and age. You also need to consider whether you are impulsive, which can lead you to sell if the stock market crashes and you become scared. To achieve the average return, you must have the courage to “sit” in a market downturn so that you are still invested when the stock market recovers. This is why choosing your asset allocation is a personal decision.
My recommendations for my financial planner clients were always based on the assumption that they worked hard for their money and did not want to be exposed to significant investment loss. We wanted long-term growth, but protecting them on the downside was just as important. Therefore, I tended to be conservative in my recommendations, especially for my retired clients.
I am aware of how quickly the stock market has recovered from recent downturns. Investors were lucky. Yet, I don’t expect that to always be the case. If you had invested $10,000 in 1966, you wouldn’t have recovered the $10,000 (including inflation) until 1982. That was an incredibly long payback of 16 years. While this example may seem like an eternity ago to many, it was in the late 1970s and early 1980s when the United States had extremely high inflation. Inflation is now 7.9%, which is higher than it has been since the early 1980s.
Jason Zweig (of The Wall Street Journal) wrote a book called Your Money and Your Brain. In his book, he tells a fascinating story about Harry M. Markowitz. Markowitz is well known in the financial industry for his theories of risk and return and “Modern Portfolio Theory”, which he created and which led to a Nobel Prize in Economics in 1990. Zweig tells the story :
In the 1950s, a young researcher at the RAND Corporation wondered how much of his retirement fund to allocate to stocks and how much to bonds. An expert in linear programming, he knew that “I should have calculated the historical covariances of asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market was going up and I wasn’t in it or if it was going down and I was all in it. My intention was to minimize my future regrets. I therefore split my contributions 50/50 between bonds and equities.
One might have expected an economist to use the statistical analysis of his own portfolio to determine his asset allocation. However, Markowitz acknowledged that measuring risk and return was only part of the solution. He knew that human behavior (and how our brains cause us to react to stock market fluctuations) cannot be predicted or controlled by theories and statistics. Markowitz understood how powerful emotional behavior can be. He was well ahead of his time.
The fact that Markowitz considered the uncertainty of his emotional behavior in managing his finances has become a fascinating area of research called behavioral finance.
If you have a financial advisor, discuss your asset allocation. Make sure the asset allocation used in your investment accounts is what you want it to be. If it seems too aggressive – or too conservative – ask your advisor to change it. If you don’t have a financial advisor, I recommend spending the time necessary to manage your asset allocation in your investment accounts.
Suppose you decide to use a 50/50 asset allocation. I recommend that you review your investment accounts at least twice a year, as the allocation will likely change to become more stock or bond heavy in the previous six months. In other words, if the stock market is strong, you may find that your asset allocation has increased to 55% or more in stocks. If the stock market drops, your asset allocation may drop to 45% or less in stocks. If the stock and bond markets experience large swings, the change in your asset allocation may become more drastic. Rebalancing your accounts is very important.
Limited space does not allow this article to discuss in detail the pros and cons of stocks versus bonds. Some readers may expect bond prices to fall (and yields to rise) in 2022 due to the Federal Reserve raising interest rates. This happened during the first quarter of 2022, when US bond prices fell about 6%. However, in my opinion, this does not justify using a higher percentage of equities in your asset allocation. Stocks are generally much more volatile than bonds, as seen in the 33% drop in stocks (the S&P 500) that occurred in March 2020 at the onset of the coronavirus pandemic. Bonds generally act as a buffer, protecting investors from wild swings in stocks.
We can’t control the short-term fluctuations in stock and bond markets, but you should always feel in control of your finances. Managing your asset allocation is a good starting point for gaining control.
Donna Skeels Cygan, CFP, MBA, is the author of “The Joy of Financial Security”. She was a paid financial planner in Albuquerque for more than 20 years before retiring in 2021. She welcomes readers’ emails at [email protected]