In the world of finance, there’s no shortage of acronyms, abbreviations and terminology to complicate what is otherwise basic, straightforward concepts.
One of the most powerful of these concepts is asset allocation. Asset allocation is a technical-sounding term, but it simply describes how much of various asset types to allocate or hold in your investment portfolio.
Just as the gas and brake pedals control the forward momentum of a car, your asset allocation decisions determine the level of potential return and influence the pace of returns in your portfolio. Numerous studies have shown that asset allocation—the percentage mix of stocks, bonds and cash in your portfolio—has a far greater impact on portfolio returns than stock picking or the hopeless attempt at market timing or the crystal ball that your broker claims he possesses1.
A properly diversified portfolio typically consists of two primary components: risk assets and low-risk assets: For simplicity, think stocks and bonds. Your asset allocation is defined by how much of your aggregate portfolio (including brokerage accounts, IRAs, 401(k)s and so on) is risk oriented (eg., stocks and stock-like instruments) and how much is ballast oriented (eg., bonds and cash). Stocks have historically had a higher level of short-term volatility – the most common measure of risk – as well as higher returns over the long-term: They are your gas pedal.
Bonds, history has shown, are much less sensitive to market swings, and can protect your portfolio from freefall during the sorts of volatile markets we’ve seen from time to time. Again, history has shown us that over longer periods of time, stocks earn more than bonds, and bonds earn more than cash. Using this historical trend to your advantage is what separates investors from gamblers.
Effective asset allocation is little more than discipline and diversification, and should be memorialized in what’s known as an investment policy statement (IPS)—a document that clearly lays out how your money is to be managed. Your IPS should include a target asset allocation that is customized to your individual goals, tolerance for risk, and the timeframe in which you’ll need these funds..
It’s important not to change your asset allocation frequently or even re-balance too often. The stock market is a long-term investment tool in which the average cycle (the period from highs to lows and back to highs) lasts about six to ten years. At AdvicePeriod, we recommend that investors plan to hold their investments in the stock market for a minimum of three to five years. Because your allocation is based on your goals, your timeline and your ability to keep calm during market storms, it should only be adjusted in the event of a material change in your circumstances, not a change in direction of the stock market. Said differently, an asset allocation change should always be proactive, not reactive.
The asset allocation you set through your IPS will act as the blueprint for your financial future. To extend the car analogy, you can think of your IPS as a GPS: Your asset allocation plan, combined with the guidance of a professional advisor, can help you navigate safely to your destination.