The Importance of Asset Allocation & How to Get Started
Asset Allocation: The First Step to Achieving Your Investing Goals
By: Erin Slocum CFP®
You have no doubt heard the saying, “Don’t put all of your eggs in one basket.” This sums up the role of asset allocation when it comes to maximizing returns on your investments. Studies have shown that asset allocation, not security selection or market timing, is the main driver of investment returns over time.
In 1986, Gary Brinson, L. Randolph Hood, and Gilbert Beebower conducted a landmark study that determined that asset allocation is the most important determinant of investment returns. According to the study, more than 90% of the variability of a portfolio’s performance over time is attributed to its asset allocation.
What is Asset Allocation and Why is It Important?
Asset allocation is the process of dividing your investment assets among the three primary asset classes of equities (or stocks), bonds (or fixed-income instruments) and cash/cash equivalents, with the goal of reducing portfolio risk and volatility by not putting all your investment assets (or eggs) into a single asset class (or basket).
Most investor’s asset allocations will be different. Your specific asset allocation will be based on your personal goals, risk tolerance and investing time horizon. If you’re relatively young and are investing for retirement, for example, you have a long-term time horizon, and might choose a more aggressive asset allocation strategy. But if you’re older and nearing retirement, you have a short-term time horizon and might choose a less-aggressive allocation.
The asset allocation roles of stocks, bonds and cash equivalents are as follows:
- Stocks — To maximize total return in order to grow principal, and secondarily to generate current income.
- Bonds — To minimize portfolio volatility, serve as a deflation hedge and generate current income to support spending and liquidity needs.
- Cash equivalents — To provide liquidity and guard against unanticipated volatility.
Diversification and Reaching Your Goals
The power of diversification isn’t simply about mixing high-risk investments with low-risk ones. Rather, diversification is enhanced or diminished by how closely the components move together. During pronounced equity market gyrations, planning for one’s financial future becomes incredibly difficult, and thus there is a need for diversification.
For example, someone may want to purchase a home in the next couple of years and at the same time continue to save for their retirement in 20 years. They would want to invest in assets that are less volatile to ensure they will have the funds available to buy their house, coupled with investments that are higher on the risk spectrum in return for greater growth potential to increase the likelihood they will have enough money to live on in retirement.
An investor that wants to leave their estate to a charity or their grandchildren can afford to invest in more volatile assets that have greater growth potential, as well as alternative investments that have a longer lock-up period. At the same time, they may depend on their investment portfolio to support their lifestyle and therefore would be invested in less volatile securities and own more income producing assets.
While no investment strategy can guarantee success, our view is that diversification is the best tool in your toolbox to help you reach your long-term goals.
The Role of Alternative Investments
High and ultra-high net worth individuals and families should consider adding alternative investments to their portfolio as a fourth asset class category. Alternatives incorporate a wide range of investments beyond traditional stocks, bonds, and cash equivalents. These include real estate, private equity, venture capital, commodities, and hedge funds.
Alternative investments tend to have a low correlation to traditional asset classes and therefore offer the opportunity for further diversification to help mitigate downside portfolio risk. For example, in volatile equity markets where stock indices are negative, we would expect alternative investments to outperform. Or, in low interest rate environments they may offer higher returns or income than traditional fixed income investments, thus serving as an inflation hedge. Put another way, alternative assets tend to zig while traditional asset classes zag, and vice versa.
Note that only accredited investors and qualified purchasers can purchase alternative investments. An accredited investor is someone with a net worth of at least $1 million (excluding their primary residence) individually or jointly with their spouse, or a sustained annual income of at least $200,000 (or $300,000 for married couples). In addition, many alternative assets are less liquid than traditional investments like stocks and bonds, which can easily be bought and sold in the secondary marketplace. Hedge funds and private equity funds, for example, can only be liquidated during certain time periods or may have long lock-up periods.
Changing Your Allocations and Rebalancing
Once you have established your asset allocation, rebalancing is the process by which you keep your allocation in line as markets go up or down. One approach is to periodically rebalance your account, for example annually or bi-annually. However, there are a variety of strategies for rebalancing your portfolio and they can all be impacted by your individual situation.
Separate from rebalancing, there may be times in which you’ll want to consider changing your allocation parameters overall. For example, if you are planning to purchase a home, having a higher allocation to cash would make sense. Or if you are approaching retirement, increasing your allocation to fixed income can help protect you from market fluctuations as you plan to live off your savings. Essentially any changes to your goals or life situation would necessitate a review of and change to your asset allocation.
Approaches to Asset Allocation
Financial advisors need to develop a deep understanding and appreciation for their clients’ financial needs and expectations over their investing time horizon. At Simon Quick, this information is captured in an Investment Policy Statement (“IPS”) that defines the objectives, risk criteria, investment selection, monitoring procedures, measurement standards, and asset allocation guidelines for a particular client.
Once the IPS is approved by the client, our team begins the process of constructing a personalized, multi-asset portfolio. At Simon Quick, our financial advisors have access to the entire universe of investment opportunities, including alternative investments, which gives us the flexibility to build customized portfolios designed to achieve our clients’ goals.
A Dynamic, Personal Process
We firmly believe that an intentional combination of asset classes that is driven by your objectives and financial situation coupled with ongoing monitoring and rebalancing, is essential to your success in achieving your goals no matter the market environment.
Designing and implementing the right asset allocation is a dynamic, personal process that’s different for every investor. We work closely with clients to make sure that their financial plans are protected by an optimal asset allocation; the critical first step to achieving their financial goals.
We would be happy to answer any questions you have about behavioral finance and removing emotions from financial and investing decisions. Feel free to call us at (973) 525-1000 or send an email to email@example.com.
About Erin Slocum
Erin joined Simon Quick in 2022 as a Client Advisor. She works directly with high-net-worth individuals and families providing investment advice and financial planning services to help them achieve their financial goals. Prior to joining Simon Quick, Erin worked at BNY Mellon Wealth Management where she where she provided financial planning and investment management services to high-net-worth individuals and families in the US and abroad. Erin graduated from The George Washington University in 2008 with a BS in Economics. She earned her certification in financial planning at NYU School of Professional Studies and became a CERTIFIED FINANCIAL PLANNER™ in 2017. She serves on the board of the Financial Planning Association of Metro New York chapter where she is currently president and is involved in the membership and pro bono committees. To learn more about Erin, connect with her on LinkedIn.
 Gary P. Brinson CFA L. Randolph Hood, Gilbert L. Beebower “Determinants of Portfolio Performance,” Financial Analysts Journal, January 1, 1995
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