A while back, we wrote The College Student's Guide to Investing, a great tool to help you get started investing. We covered various angles including the importance of starting now, continuing your investment education through continuous learning, and lowering costs through index fund investing. And once you have your accounts setup and funded, what then? What investment strategies should you use to reach your financial goals? There are obviously many different ways to invest your money, and there really is no once-size fits-all approach. Every individual has unique needs and goals, and so choosing the right style of investing for you is more of an art than a science. In this post, we will explore asset allocation.
Asset allocation involves choosing a diversified portfolio of investments based on various factors. These include your age, risk tolerance, and investment goals. Asset allocation is not a perfect investment strategy. It has critics and flaws. But in general, it can be a good way for a beginning investor to start. It is relatively simple to use, and once you understand the basics, you can usually manage your portfolio with minimal effort.
Of course, it is always prudent to pay attention to market fluctuations. But you should probably be trading only three or four times per year with a properly diversified portfolio. Trim asset classes that are overweight due to appreciation, and use the proceeds to add to your existing holdings. Execute these trades during your scheduled portfolio rebalancing. Rebalancing is important because it allows you to keep your portfolio allocation in line with your long-term investment objectives.
Getting Started With Asset Allocation
Many young investors get started with asset allocation at work with a 401(k) or an equivalent qualified plan. The principles of asset allocation will work just as well in taxable cash accounts or tax-free accounts like a Roth or Traditional IRA. The only real difference might be the fixed income allocation. Depending on your situation, you might want to keep the bond portion of your taxable account invested in tax-free fixed income instruments, like municipal bonds.
Once you have your account open, it’s time to pick an allocation. Let’s look at an sample portfolio.
Aggressive Asset Allocation Model Portfolio Example
This is just one example of an aggressive asset allocation portfolio model. This model makes several assumptions:
- Tax-free account. In this example, we are using a Roth IRA.
- 40+ years to retirement.
- No need for withdrawals before retirement age
- Investor is completely comfortable with market volatility and market swings. This allocation is very aggressive and the value can fluctuate dramatically.
There are wide varieties of asset allocation models available. These can guide you in choosing a portfolio. But sample portfolios are just basic guidelines. You can customize and tweak them until they fit your goals.
This is a list of some possible ETF holdings for the IRA. Again, this is just a sample list using some low-cost index ETFs. It is a good idea to use index ETFs to build your portfolios. An all-index ETF portfolio has several advantages. They offer a good combination of low fees along with broad, index-based industry, sector, and country exposure.
- Large Cap Domestic Stock – S&P 500 ETF – VOO
- Mid Cap Domestic Stock – Mid-Cap Value – VOE
- Small Cap Domestic Stock – Small-Cap Growth – VBK
- Developed Foreign Markets Stock – MSCI EAFE Index Fund – EFA
- Emerging Market Stock – Emerging Markets ETF – VWO
- Commodities – DB Commodity Index Tracking Fund – DBC
- REITs – Vanguard REIT ETF – VNQ
- Emerging Market Bonds – – JP Morgan Emerging Markets Bond Fund – EMB
Of course, it is possible to build a portfolio using any combination of ETFs, mutual funds, or stocks and bonds.
Dollar Cost Averaging Versus Lump Sum Investing
We covered dollar cost averaging versus lump sum investing in a previous post. But given the current state of the market, it is worth exploring again. One of the more glaring downsides to asset allocation portfolios involves market timing. Going “all in” at the wrong time can have disastrous consequences. For example, consider an investor who uses the aggressive portfolio example above. If this investor had gone “all in” with this example in September of 2007, the account would have lost significant value. Using dollar-cost averaging to ease into the market over time can help preserve capital and protect from damaging losses.
Dealing With Your Emotions
Keeping your emotions in check is a very important part of investing and asset allocation. It can be difficult to watch the value of your portfolio fluctuate wildly, especially during down markets. Sometimes it seems easier to just throw in the towel and quit. But maintaining a long-term outlook, as well as a disciplined approach, can help calm your nerves and help you weather short-term storms.
This is probably some of the easiest investment advice to give, but the hardest to implement. Managing your own money involves significant emotion. That is one reason why many people choose to hire a professional money manager.
Concentrated Investing As An Alternative
Asset allocation is just one option on the the path to financial freedom. An alternative approach to asset allocation would be concentrated investing. With concentrated investing, and investor might focus his or her efforts on holding just 5-10 stocks at a time in their portfolio. This approach is probably best suited for active investors who have the time to do extensive fundamental and technical research.
Of course, you could also use both approaches at once. One strategy might be to maintain a diversified portfolio using the principles of correct asset allocation, while at the same time opening another, more speculative account. You could use the account to trade stocks, options, or riskier assets. In this way you satisfy your urge to “play the market” while at the same time protecting your hard earned funds.
Asset allocation is not likely to make you rich quickly. It has its flaws, but can also be a good tool to use on your journey to a comfortable retirement. In short, asset allocation is a good way to reach your retirement goals slowly and help you build wealth over time.
What are your thoughts on asset allocation? How does your portfolio break down?