Asset Allocation
Let me be your Guide (cue spooky music)
“Come on crystal ball, show me what my asset allocation should be. I have been staring at you for hours and this book is useless. Then show me my future”
There is no magic when it comes to asset allocation. What? The mere suggestion that there is no magic to asset allocation is financial blasphemy. An entire industry exists around asset allocation but I will tell you there is no perfect formula. And sadly no one uses a crystal ball.
Deciding how much to invest in stocks, bonds, and cash is personal. And there is no doubt that asset allocation is important. I just believe that for most of us asset allocation is a lot less complicated than it appears.
The reason to focus on asset allocation is to build a framework. The asset allocation framework will guide you. If you focus on your framework first it is easier to sort out what to invest in.
Today we are going to keep things simple. We are going to focus on the three basic asset classes: stocks, bonds, and cash.
Conventional wisdom is to recommend investing 60% in stocks, 30% in bonds and leave 10% in cash. This makes no sense to me. (note that in asset allocation the percentages always add up to 100%)
It makes no sense because regardless of your age, your risk tolerance, or financial goals, asset allocation is not one size fits all.
Practically, you cannot allocate exactly 60% to stocks, 30% to bonds and 10% to cash. You cannot allocate exactly because as the prices of your securities change, the percentage allocation automatically changes.
Asset allocation is not precise, that is why you need a fortune teller, sorry, a framework. In investment language guidelines are your framework.
Using a 60/30/10 rule reminds me of the TV show Monk. Monk was a private detective with extreme obsessive-compulsive disorder. Everything in his life had to follow a specific rule. He was great at solving gruesome murders if his life was in perfect order. But can you imagine the chaos of trying to keep his investments perfectly allocated? He would hate having 61% in stocks, 32% in bonds and 7% in cash. Yes, I do know he is a fictional character
Guidelines are like buckets. Orange bucket – stocks. Purple bucket – bonds. Green bucket -cash. You are going to decide how much to allocate to each bucket. Instead of one number like 60%, think about asset allocation in terms of ranges.
| Asset Allocation | No less than | No more than |
| Stocks | 30% | 70% |
| Bonds | 20% | 60% |
| Cash | 5% | 10% |
| Total |
- My stock bucket should be at least 30% full but no more than 70% full.
- My bond bucket should be at least 20% full but no more than 60% full.
- My cash bucket should be at least 5% full but no more than 10% full.
- My current stock allocation is 70%, my bond allocation is 20% and my cash bucket is 10%. All buckets equal 100%.
With ranges you can maneuver. You can change how much is in each bucket. If your stock bucket is full and you have nothing in bonds or cash, you might want to reallocate from your stock bucket to your bond and cash buckets. Having buckets for each asset class is one way to manage risk.
Consider the following:
|
Asset Allocation |
Year End |
Range |
Rebalance |
Beginning of Year |
| Stocks | 84% | 30%-70% | Sell 24% | 60% |
| Bonds | 13% | 30%-60% | Buy 17% | 30% |
| Cash | 3% | 5%-10% | Buy 7% | 10% |
| Total | 100% | 100% |
In the scenario below, your stocks have done well. Congratulations! Prices have gone up, so your stocks are worth a higher percentage of your portfolio and above the range where you feel comfortable. The allocation to bonds has dropped below your minimum level of 30%. Cash is below the minimum of 3%.
What do you do and how often do you do it?
The reason to have ranges is that you are not going to reallocate or rebalance every day or every month. You might reallocate once or twice a year at the most.
What you are going to do is take some (not all) of your gains in the stock market and invest in the bond market and cash equivalents. The term used is “locking in your gains” or “realizing your gains” *
In the table above, you would sell 24% of your stock position and buy 17% in bonds and add 7% to cash so that each asset class is within range.
Rebalancing decreases the risk of having too much of one asset class in your portfolio.
The reason we use percentages is that you can apply the same bucket theory and percentages to any portfolio regardless of the monetary value.
The percentage increase or decrease will determine the dollar amount needed to rebalance your portfolio.
In the table below, we are going to do some simple arithmetic (Monk Math Made Easy) to show you what rebalancing looks like.
I have a portfolio that is worth $100,000.00. Eighty four percent of the portfolio is invested in stocks. That is equal to $84,000.00.
- I am going to sell 24% of my stocks ($24,000.00) to reduce my stock exposure to 60% or $60,000.00.
- I am going to add $17,000.00 or 17% to bonds. Now I have $30,000.00 or 30% in bonds.
- I am going to add $7,000.00 to my cash. Now I have $10,000.00 or 10% in cash.
- I am now within the range for each bucket.
|
$100,000.00 |
|
New Total |
In Range | |||
| Stocks | 84% | $84,000.00 | Minus 24% |
$24,000.00 | $60,000.00 | 60% |
| Bonds | 13% | $13,000.00 | Plus 17% |
$17,000.00 | $30,000.00 | 30% |
| Cash | 3% | $ 3,000.00 | Plus 7% |
$ 7,000.00 | $10,000.00 | 10% |
| Total | 100% | $100,000.00 | 0 | $100,000.00 | 100% |
There is another way to think about your asset allocation:
Define what risk means to you. Don’t label yourself or put yourself into a box. Terms like conservative, risk adverse, aggressive growth or income can all be a part of your portfolio.
You might decide to invest 2% of your portfolio in a high-flying tech startup. That doesn’t make you aggressive or risk seeking. It means that you are willing to accept a loss in the event the company goes bust. Accepting a loss is a “worst case” scenario.
Ask yourself the following question: how much can I afford to lose?
If you have $100,000.00 and you lose 10%, can you stomach a $10,000.00 loss?
If you can’t stomach the thought of losing $10,000.00 but you could live with a loss of $2,000.00, that means you should not invest more than 2% in any one holding (stock, bond, mutual fund, or ETF).
We all want the upside and positive returns. The reality is that losses will occur. Most people are much more sensitive to the losses than to the gains.
Getting the feel for what asset allocation is right for you is the first step in building your portfolio and managing risk.
The second step is to think about acceptable losses and limit your positions.
To Do:
If you have a portfolio, you might want to review how much, in percentage terms you have allocated to each asset class. Other assets classes include commodities and real estate.
*For investments outside of a qualified retirement plan, known as a taxable account, be sure to check with an accountant or tax planner regarding realized gains and losses. Short term gains and long-term gains are taxed at different rates.
Asset Allocation Part Two will have more detail on including other assets classes and understanding how to allocate within asset classes.
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
