Let’s introduce two important concepts: asset allocation and asset location. They are two very important terms in personal financial management. They may appear similar but they point to very different aspects of one’s financial structure. In this post, I will discuss a bit about asset allocation.
Asset allocation is essentially the pie chart of your portfolio. Here’s the asset allocation of Joe, a fictional friend of ours. What do you think about this asset allocation?
Your asset allocation demonstrates your investment strategy including your risk tolerance, goals, investment time frame, etc. How does a pie chart demonstrate all these factors? It provides clues according to current agreed upon rules of personal financial investment. Obviously, not everyone is following the same investment rules. But in general there are a few rules of thumb:
- Riskier investments can provide higher returns. In general, stocks tend carry higher risks than bonds thus are usually seen as investment assets with higher growth potential. Everyone has a different appetite for risks so not everyone is putting 100% of their money into stocks even though stocks generally provides a better return. Wise investors tend to have a good gauge on how much risk they can stomach and allocate their assets accordingly. This is a critical characteristic of a savvy investor. The last thing you want to do is panic during a market downturn and fall into the classic trap of buy high sell low.
- You will want to take less risk as you get closer to your retirement. As we get closer to retirement, we have less time to make up losses if we mess up our investments. You will really want to minimize risks by putting more and more of your asset into safer investment vehicles such as bonds, CDs or even cash. If you have been managing your own 401k investment, you have probably seen many funds with titles similar to “target retirement 2030”. These are funds that will adjust your asset allocation as you get older with 2030 being your targeted retirement year. Needless to say that a 2050 fund is going to be more aggressive than a 2030 fund in its asset allocation.
- You are probably less risk tolerant than you think. I think this rule is probably the most important to people who are designing their investment portfolio for the first time. I am a fairly risk averse person. My portfolio is very conservative for someone in his early 30s. But I am comfortable with my portfolio. I sleep well knowing that I have plenty of stable assets even if the market crashes today. And this is important. I have never really experienced a bear market myself and I truly won’t know how I will react when my life savings shrivel away 50% in a week. I advise people who are not sure how risk tolerant they are to be conservative as well. Perhaps instead 80/20 stock to bond portfolio, you should considering 70/30 or 60/40 until you are more tested.
Look back at the pie chart in the previous page, what do you think? Is Joe aggressive in his investment? I think so. Aside from 40% of real estate (equity of the house Joe lives in), 91.7% of his investment is in the stocks. This is a very aggressive portfolio. Joe is either extremely risk tolerant or a fool in my opinion. Considering that Vanguard Total Market Fund (VTSAX) returned 18.47% before taxes in last year and 14.54% per year in the last five years before taxes, it is not surprising that many people are aggressively chasing the returns. However, do not underestimate the reverse of rule 1: higher returns expose you to higher risks.
What do you think? Am I explaining this concept well enough? How aggressive or risk averse are you in your asset allocation?