Building Your Portfolio, Part 2: Asset Allocation

Building Your Portfolio, Part 2: Asset Allocation

Welcome to Part 2 of my Building Your Portfolio series of blog posts.  In the last post we discussed the basic accounts you should consider when building the foundation of your investment portfolio. Today I’d like to discuss the proportion of each asset class you should consider investing in, otherwise known as asset allocation.  

Disclaimer: Please remember that I am not a financial professional. This blog post is for informational and entertainment purposes only.  Please consult a financial planner, financial advisor, certified public accountant, or other financial professional before making decisions regarding your investments, retirement, and finances.

What is Asset Allocation?

Asset allocation refers to the strategy of dividing your portfolio among different asset classes.  Classically this refers to what percentage of a portfolio is held in stocks and bonds.  It is common to hear phrases like “I have an 80/20 portfolio,” which would mean the portfolio consists of 80% stocks and 20% bonds.  Asset allocation could also refer to other asset classes such as cash or real estate.  An investor might say “I have 50 percent of my portfolio in stocks, 25% in real estate, 20% in bonds, and keep 5% in cash.”

Why is Asset Allocation Important?

Many consider asset allocation to be one of the most important financial decisions you can make regarding your investment portfolio and financial future.  In fact, many financial experts feel your asset allocation is even more important than the specific investments you choose within each asset class.  

Here are at least three reasons asset allocation is important when building your investment portfolio:

Risk Reduction

No one wants to lose money.  I think we can all agree on that point.  However, investing, by definition, is associated with at least some risk.  Thus, it’s only natural for each of us to want to reduce the amount of risk we take when investing, while still preserving (and maximizing) the possible reward.  Proper asset allocation helps us to do that.  

When your investments are divided in a reasonable asset allocation, it reduces the overall risk of your portfolio.   

• You reduce the risk of losing all of your money in a market crash.  
• You reduce the risk of falling short of your financial goals.  
• You reduce the risk of running out of money in retirement.  

One of the main reasons an appropriate asset allocation reduces risk is diversification.   You don’t have all of your eggs in one basket.  Ideally, you have them in many baskets that aren’t directly correlated with each other.   So when one one basket (or asset) loses value, the others maintain their value.   Furthermore, your investments are weighted in assets that are appropriate for your financial goals and time horizon.   

Decreased Volatility

Spreading your investments across varied asset classes also decreases the volatility of your portfolio.  Volatility is the day to day, week to week, and month to month fluctuation in the value of your investments.   For example, a 100% stock portfolio will be extremely volatile (meaning there will be huge upswings and downswings in prices over time) because that is the nature of stocks.  Some people are unable to withstand this level of volatility and do the worst thing possible . . . they give in to fear and sell their stock holdings when the market drops or crashes.  Just look back to the Great Recession in 2008 and the recent bear market due to the pandemic in March 2020.  Many investors sold at the bottom, which at best sets them back for many years, and at worst devastates them financially for the rest of their lives.  

On the other hand, if you have a 60% stock and 40% bond portfolio, you have a significantly decreased level of volatility compared to the 100% stock portfolio, which means you won’t see as large of price swings in the overall value of your portfolio over time.  This is because bond valuations are not typically correlated with the stock market and remain relatively stable.  As J.L. Collins eloquently states, “bonds help smooth the ride.”  This decreased level of volatility often provides investors with enough stability to weather the periodic financial storms that come with investing.

Promotes Good Investing Behavior

Believe it or not, sticking to a proper asset allocation also promotes good investing behavior.   This is why, in my opinion, your asset allocation should be a key part of your overall financial plan.  

First, a well thought out asset allocation helps you to invest in line with your financial goals, risk tolerance, and time horizon.  We will discuss each of these factors next.  

Second, sticking to your asset allocation keeps you from jumping on the bandwagon and buying the next hot stock or cryptocurrency or whatever.  It gives you a framework to maintain a disciplined investing approach that is most likely to give you the best returns over time.  

Third, your asset allocation prevents you from losing money when you rebalance your portfolio.  It prevents you from “buying high and selling low” and actually causes you to do the opposite, “buy low and sell high.”  I will discuss how this works in detail in a future post on rebalancing.  

What Factors Affect Asset Allocation?

Before determining your asset allocation, you need to understand the factors that affect it.  Keeping it simple, I think there are at least three factors you should consider when determining your asset allocation.  While they are each different, they are also related to one another.  

Risk tolerance

Risk tolerance is how much risk you are willing to accept in your investment portfolio.  There can be a significant amount of variation in risk tolerance from one investor to another.  Risk tolerance is dependent on a large number of variables including personality, income, age, financial goals, stage of life, etc.  

I believe there are two components to risk tolerance.  The first is psychological.  This really is whether or not you will lose your cool when the market goes south.  If you can’t stomach the ups and downs of the market, you have a lower risk tolerance.  Conversely, if watching your portfolio drop by 50% in a financial crisis doesn’t cause you to break a sweat, you have a higher risk tolerance.  

The second component is practical.  This varies based on what stage of life you are in and when you plan to use the invested money.  If you are young with a very long time horizon until retirement, meaning it will be decades until you actually need your nest egg, then you have a higher risk tolerance because there is ample time for your portfolio to recover from multiple significant downturns in the market.  On the other hand, if you are only five years from retirement, a major market crash could really hurt your portfolio if it is aggressively invested and you have a lower practical risk tolerance.  

Financial goals

Your financial goals matter a lot when determining your asset allocation.  Let’s consider two different situations to demonstrate how different financial goals affect the asset allocation of an investment portfolio. 

First, let’s consider a 25 year-old investor saving for retirement.  This investor’s primary financial goal is wealth accumulation and she has many decades to do it.  Because she is trying to grow her wealth and has a long time to do it, she may choose a very aggressive portfolio heavily weighted in stocks.  This type of asset allocation gives her the potential for the highest rewards, but also has the highest risks.  However, given the many years she has to achieve this goal, she is confident she can recover from any market declines over this extended period of time.  

Next, let’s consider a 65 year-old recently retired couple.    They have a sizable investment portfolio that will cover their living expenses by the 4% rule.  They no longer need their wealth to grow, they just need to make sure it doesn’t run out.  Their primary goal is wealth preservation.   Instead of being aggressively invested in the market like our 25 year-old, they choose a much more conservative 50/50 asset allocation more in line with their financial goals.  

Your financial goals could include other things such as buying a new home, paying for your kid’s college, starting a business, or purchasing real estate.  Each goal may have its own asset allocation, or affect the asset allocation of your portfolio as a whole.  

Time horizon

Time horizon refers to the amount of time an investment is held before it is liquidated, which is typically determined by the investor’s financial goals.  If the investor is saving for a down payment on a home in the next two years, there is a short term time horizon.  If the investor is 35 years-old and saving for retirement, with a goal retirement age of 65, this would be a long term 30 year time horizon.  

An investor’s time horizon will strongly influence many factors in his or her portfolio, including asset allocation.  An investor with a long term time horizon will likely have a more aggressive asset allocation with a heavy weighting towards stocks.  Conversely, an investor with a short term time horizon will more likely have a conservative asset allocation with cash or bonds more heavily weighted.  

Determining Your Asset Allocation

Now that you understand why asset allocation is important, and the factors that influence it, you need to decide what asset allocation is right for you.  

This may seem overwhelming.  Entire books have been written about determining your ideal asset allocation.   But rather than drift into the weeds, focusing on the intricacies of Modern Portfolio Theory or the concepts behind Factor Based investing, I prefer to keep things more simple (at least when you’re starting out). 

While I agree that asset allocation is very important, and something you certainly need to understand, I don’t think it is something you need to overly stress about and lose sleep over.   One problem some people have is they get so worked up about figuring out the “perfect” asset allocation, that they never get around to investing their money (the classic analysis paralysis).  

There is good evidence that much more important than deciding if you should allocate 20% to bonds or 25% to bonds, is formulating any reasonable asset allocation based on sound financial principles AND THEN sticking to it in both good and bad financial times.  

Furthermore, your asset allocation isn’t locked in stone.  As your knowledge about investing increases or your circumstances change, you can always adjust your asset allocation to better fit your financial needs (so long as it is not reactionary to a financial crisis or downturn).  

Let’s establish some basic assumptions (I’ve alluded to these already):

• Stocks have the highest potential for reward, but also the highest risks.  They are also extremely volatile.  They are more appropriate for financial goals with a time horizon greater than 5 years.

• Cash (and cash equivalents) have the lowest reward and the lowest risk.  Allocations to cash are more appropriate for short term savings goals (1-2 years) and an emergency fund (where you need liquidity and the ability to preserve/use the money despite any market fluctuations).  

• Bonds fit in the middle.  They generally have lower returns and lower risk compared to stocks, but higher returns and more risk compared to cash.  Bonds help smooth the ride and provide some relatively predictable fixed income in the form of dividend/interest payments.  

• Alternative investments can also comprise a percentage of your portfolio, but certainly aren’t required.  If you do decide to include them in your asset allocation, make sure they are stratified according to risk (most are considered to have risk similar to or greater than stocks). 

Since this series of blog posts is about building a basic investment portfolio, let’s look at the most basic asset allocation strategy: age based asset allocation.  I will omit an allocation to cash for simplicity, but remember the principle of keeping a cash emergency fund, as well as potentially some money set aside for future investments.  

Age Based Asset Allocation

Many investors start with a simple age based asset allocation.  This strategy is meant for retirement, not short term financial goals.  

The basic concept behind this approach is that when you are young, you have a very long time horizon until retirement.  This allows you to start with a very aggressive portfolio heavily weighted towards stocks.  As you get older, your time horizon shortens and you gradually adjust your portfolio to become more conservative over time.  When you are eventually living off your portfolio, and it is more difficult to tolerate the volatility of the market, the portfolio is more heavily weighted towards bonds.

For many years, financial advisors have used a basic rule of thumb to estimate this age based asset allocation:  100-age = allocation to stocks.  The remainder is invested in bonds.  So, if you are 40 years old, your portfolio would be 60% stocks and 40% bonds.  If you are 70 years old, you would hold 30% in stocks and 70% in bonds.  As you can see, as you age over time, your asset allocation gradually shifts away from stocks and more towards bonds.  

Many investors feel like this rule of thumb is too conservative or outdated and advocate for a 110-age, or even a 120-age, allocation to stocks.  This, of course, depends on your risk tolerance and financial goals as we discussed above.  

Based on your current age, what would your asset allocation be using this method?  Do you feel like this is too aggressive or too conservative for you?

More Complex Asset Allocations

Of course, there are more variations and strategies for asset allocation than you can count. 

Some investors further break down the percentage they allocate to stocks into domestic stocks, international stocks, growth stocks, value stocks, large vs mid vs small cap stocks, or by financial sector (tech vs healthcare vs energy vs consumer defensive, etc.).

Similarly, bonds can be divided up into long term bonds, short term bonds, corporate bonds, US treasuries, international bonds, Treasury Inflation-Protected Securities (TIPS), municipal bonds, etc.  

Some investors also include many different alternative investments as well.   Alternative investments may include real estate, private equity investments in small businesses, commodities, cryptocurrencies, angel investing, venture capital, collectibles, etc.  

As you can see, asset allocation can become infinitely complex.  However, when you are first constructing your investment portfolio and determining your initial asset allocation, it is better to focus on the basics and keep things simple.  Over time you can slowly increase the sophistication of your asset allocation and portfolio if you so choose.  

Here are some guiding principles to keep in mind:

• Your asset allocation should be simple to understand and easy to maintain

• Your asset allocation should be one you can stick to through good times and bad 

• Until you’ve gone through a bear market or two and truly understand your risk tolerance, it is better err on the side of being a little more conservative

Achieving Your Asset Allocation

After you have determined a reasonable asset allocation, you need to have a plan to implement it.  What do I mean? Well, let’s say after taking all of the aforementioned factors into consideration, you feel like a 70/30 asset allocation is right for you. Great! But now what? How do you put this plan into action? 

Step 1

First, you need to understand what you are already invested in.  Odds are you already have some money invested in your employer sponsored retirement plan, or perhaps in an IRA, or maybe in one of the newer online investing platforms like Robinhood or Acorns. 

You might say “I’ve heard investing in individual stocks is risky, so I’m invested in mutual funds in my 401(k).”  While this is probably true for most people investing in employer sponsored retirement plans, what’s in those mutual funds? Remember, mutual funds are still composed of individual securities (individual shares of stock and individual bonds). Are you invested in stock mutual funds?  Bond mutual funds?  Mixed mutual funds?  Target date funds?  Actively managed funds?  Passive index funds?  

You need to break down what you are actually invested in. What percentage is allocated to stocks, and what percentage is allocated to bonds? Most online platforms where your investments are held can give you a breakdown of what your holdings are, either for your account as a whole, or for each individual fund. And you can always look at the prospectus for each fund (although rarely is this necessary these days with all the online tools). As you dig into this, remember that sometimes stocks are also referred to as equities, and bonds may be referred to as fixed income. 

Step 2

Second, you have to decide what you want to invest in moving forward. After you figure out what you are already invested in, the logical question you should ask yourself is how in line your current investments are with your desired asset allocation. If your current investments already put you where you want to be, then things are pretty easy. Maintain the status quo and keep pushing forward.

If your current investments don’t reflect your desired asset allocation, then you have a couple of options, that I think really depend on your current financial situation. If you are younger and trying to accumulate wealth, I would recommend you choose future investments to invest in that will eventually result in your desired asset allocation. If you are in or nearing retirement, and don’t plan on investing significantly more money in the future, you may need to sell some of your investments in one asset class and purchase investments in another asset class to achieve your asset allocation. 

Step 3

Third, you need to decide if your asset allocation applies to each individual investing account you have, or to your overall portfolio as a whole. This is something that I don’t think gets talked about enough. 

When we started investing, I thought it made sense to keep our overall stock to bond allocation consistent in each account.  For example, if you choose a 70/30 asset allocation, it probably seems logical to keep a 70/30 balance in your 401(k), a 70/30 balance in your Roth IRA, and a 70/30 balance in your taxable brokerage account. This seems like a nice tidy way to do things.  

However, what I have found as the number of investing accounts we had increased, as our investments grew in value and complexity, and as my understanding of the variable tax efficiency associated with different investments expanded, it made a lot more sense to treat our investment portfolio as one larger whole with respect to asset allocation. Now we try to keep less tax efficient investments (like bonds and REITs) in our tax advantaged accounts, and more tax efficient investments (like stocks and municipal bonds) in our taxable accounts. 

I think both are reasonable approaches. But this is a subtle nuance that I believe investors should be aware of and plan for in the beginning as they construct their portfolio.

Step 4

Fourth, you need to establish a system to track your investments.  

Over time, the value of your investments will change as the market fluctuates, and as you invest more money. This will affect how accurately your investment portfolio reflects your desired asset allocation. How can you keep track of your overall asset allocation?  The easiest way is to use an app like Personal Capital that does this for you automatically. Another method is to use a spreadsheet to track everything manually. Since I’m kind of a financial nerd, I actually do both. 

Step 5

Finally, you have to rebalance your portfolio on a regular basis to bring it back in line with your desired asset allocation. How often? Most financial experts recommend you rebalance your portfolio on annual or semi-annual basis. I will write an entire post on rebalancing your portfolio in the near future. 

What We Do

Our investment portfolio has grown more complex over time.

We started with a basic 80/20 portfolio.  I felt like this was a reasonable allocation given the above factors: risk tolerance, financial goals, and our time horizon. We were mainly invested in low cost, broad based index funds with exposure to the US total stock market and bond market. 

As I learned more about investing, I read The Boglehead’s Guide to the Three-Fund Portfolio (I plan to write a review on this excellent book in the future). The basic strategy is to invest in a US total stock market index fund, an international stock market index fund, and a US total bond market index fund. After reading the book and many other reviews and critiques of this approach, I felt the principles and rationale were sound. Based on this, we ultimately decided to add some exposure to international stocks in our portfolio. It wasn’t a lot, but it added a little more diversification than we currently had.

I was also learning more about real estate. You can read part 1 and part 2 of my posts about why I have been so interested in real estate investing. Ultimately, we decided to make real estate investing a major part of our investment portfolio. After weighing the pros and cons of direct real estate ownership with more passive forms of real estate investing, we have decided to invest in the more passive forms, specifically REITs, real estate crowdfunding, and private equity real estate funds. 

After the onset of the coronavirus pandemic, we’ve also been more deliberate about having a solid cash position in our portfolio. This includes our emergency fund, plus a store of cash for potential upcoming investment opportunities. 

Finally, given the historically low interest rates and poor returns on bonds, combined with the fact I’ve realized in this recent market downturn that our risk tolerance is quite high, I’ve slightly decreased our bond position. 

Putting this altogether, here is the current asset allocation of our retirement portfolio:

• 50% Stocks   
  • 40% US Stocks   
  • 10% International Stocks

• 30% Real Estate   
  • 20% Private Equity Real Estate Funds   
  • 5% Crowdfunded Real Estate   
  • 5% REITs

• 15% Bonds

• 5% Cash/Cash Equivalents

We are currently in the wealth accumulation stage of our financial lives (as opposed to the wealth preservation stage).  So, in order to keep our portfolio in balance, we buy more of whatever asset class we are low in, rather than selling currently held assets.  

Conclusion

Today we discussed asset allocation in the context of your investment portfolio. In the next part of this series, we will discuss what specific investments you should consider in each of these asset classes.  Here are some take home points to consider:

• Asset allocation is one of the most important financial decisions you can make because it will help you to reduce risk, decrease volatility in your portfolio, and promotes good investing behavior which can maximize your returns over time.

• Your risk tolerance, financial goals, and time horizon are important factors to consider when determining your asset allocation.

• A simple age based asset allocation is a good place for beginning investors to start. As your investing experience increases, you can develop a more complex asset allocation strategy. However, always make sure your asset allocation is simple, easy to maintain, and something you can stick with.

• To implement your asset allocation strategy you must: 1) understand your current investments, 2) choose future investments in line with your goals, 3) decide to apply your asset allocation to each individual account or your portfolio as a whole, 4) track your investments, and 5) rebalance your portfolio on a regular basis. 

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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Sunset near our home in Eau Claire, WI.