Novice investors frequently assume that they need to master every minute aspect of investing before earning a steady return: P/E ratios, capital gains taxes, load vs. no load mutual funds, technical analysis, on and on, ad infinitum. This is a profoundly mistaken belief, and one that freezes countless investors in their tracks instead of delivering the returns they deserve.
Today, I am going to try to liberate you from this flawed notion by discussing what I believe is the most important part of successful investing: nailing down the correct asset allocation.
Very simply, “asset allocation” refers to the overall mixture of stocks, bonds, and other asset classes in your portfolio, and how much of your total capital is invested in each one. Having the right balance—the correct asset allocation—is what keeps you diversified in the market, rather than heavily invested in one thing that could fall down and take your whole portfolio with it.
The Securities Exchange Commission (the government agency responsible for enforcing stock market laws) offers a helpful example to illustrate why this matters:
Have you ever noticed that street vendors often sell seemingly unrelated products – such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never – and that’s the point. Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true. By selling both items- in other words, by diversifying the product line – the vendor can reduce the risk of losing money on any given day.
There are two key dimensions to asset allocation:
Your Time Horizon
In investing, “time horizon” refers to how many months, years, or decades you have to achieve your financial and investment goals. Your time horizon dictates how aggressive or conservative your asset allocation should be. For instance, an investor with a long time horizon (say, someone who is 25 years old and just opening a brokerage account for the first time) can be extremely aggressive, owning far more stocks than bonds. Yet, as we just learned, that asset allocation would be grossly inappropriate for a 60 year old man expecting to retire in five years. Their time horizon demands a more conservative, “play it safe” asset allocation. And I’ll give you examples of each later on.
Your Risk Tolerance
The other key dimension of your asset allocation is your “risk tolerance.” This refers to your own personal ability to tolerate risk: the possibility of losing some or all of your investment capital in exchange for potentially earning a high return. This is a more “soft” dimension than time horizon, because it is, by nature, personal rather than formulaic. Just because abstract portfolio theory says a 25 year old should be aggressive in the market doesn’t mean you will feel comfortable doing that.
That’s why it’s important to constantly ask what your end goal is, and make every decision with it in mind. Is your end goal to earn the biggest return you possibly can? If so, you need to be comfortable accepting a great deal of risk, both early on and throughout much of your adult life.
On the other hand, if you are simply seeking to beat inflation and earn more than a savings account pays, you can adopt a more conservative asset allocation—and be relatively free of worry about huge losses.
As the SEC says, conservative investors prefer to keep “one bird in the hand”, while aggressive investors would rather roll the dice and potentially get “two birds in the bush.”
The Driver of (Almost) All Investing Success
In investing, asset allocation (or the overall composition of your portfolio) is more important than any individual stock within it. That’s because while stocks run hot and cold, the correct asset allocation keeps you steered in the right direction for the long-term. Let’s say, for example, that technology stocks have a big year. Does this mean you should put 50% of your portfolio in tech from now on?
Countless investors have lost money by assuming today’s hot sector would power their portfolios forever. But it never happens. Invariably, the following year (or even the following month) is dominated by health stocks, or manufacturing, or any number of other sectors. Conversely, investors who maintain an age-appropriate asset allocation tend to win over the long-term because poor individual stocks are outweighed by the correct overall mixture. In other words, the system is greater than the sum of its parts.
Want proof? In a 1991 study, Gary P. Brinson, Brian D. Singer, and Gilbert L Beebower determined that over 90% of long-term investment volatility came from decisions about one’s asset allocation – NOT timing the market or stock picking.
In part two of this series, we’re going to analyze not just why asset allocation is important, but also samples of different allocations, how to determine the best asset allocation for your portfolio, and how to ensure that allocation remains steadily in place no matter what the market does to your investments (or how much your emotions conspire to derail you.)
First, I want to explore what might seem to be a very counter-intuitive notion: how is one factor responsible for so much of your investment returns? After all, there are so many investment vehicles out there, endless different theories about when to buy or sell, seemingly infinite opportunities to do this or that with your portfolio. Business schools teach semester-long courses on technical analysis, and some investors devote their entire lives to devising elaborate formulas that purport to time the market for high returns. Given all of this, how can simply owning the right mixture of assets virtually assure you of coming out ahead in the long run?
There are two reasons. The first is that despite the way we are wired to think, tiny actions often cause massive results. As humans, we have an ingrained tendency to think linearly. We assume that what we put in is what we get out. If we work for two hours, we assume that should produce two hours of results. But this is frequently not the case at all. A relatively small amount of effort, applied to the right area, can produce enormously disproportionate results.
- Creating a workout plan takes 1-2 weeks to research, but can add 30 pounds of lean muscle in just a few months.
- Planning a complex project takes 2-4 weeks, but can bring a 50% reduction in delays.
- Negotiating a single raise takes 1-2 hours, but can add $1 million or more in cumulative lifetime income.
Many of us would read a chart like this and fixate on the time, but that is entirely beside the point. These actions are not explosively productive because of how long they take, but because they are the things that drive disproportionate results.
Asset allocation is very similar. By taking the time to define how much of your money will be concentrated in stocks, and how much in bonds, and how much in commodities, you are laying a foundation for long-term success. Each month, as you put more and more money into your brokerage account, every dollar follows the logic set forth in your asset allocation, steering the ship of your portfolio towards your ultimate destination of wealth.
Another way to think about asset allocation is to compare it with a house. No matter how much you love French doors, or gold-tipped faucets, or breathtaking skylights, these things are not even 1% as important as the house’s blueprints: the instructions that helped the architect turn a bunch of raw materials into your dream home.
Stay tuned for Part Two, where all of these concepts will be tied together with specific examples and recommendations…