Last week, I kicked off a three-part series on what matters in investing on the supreme importance importance of getting your asset allocation right. Today, part two focuses on the deeper specifics of asset allocation, including three sample allocations to bring the idea right down to earth.
Asset Correlation & Why it Matters
More deeply, asset allocation works because it keeps you diversified and ensures you own assets that are not directly correlated with one another.
Technology stocks are subject to the same market trends, buying preferences, regulatory climates, and so forth as other technology stocks. Ditto for manufacturing, auto, or any other sector. It doesn’t matter if you own some stocks in Google, and some in Microsoft, and some in Facebook—that is not diverse enough. A portfolio made up of only those stocks is in serious jeopardy the next time a tech crash (like the one that happened in the late 1990’s and early 2000’s) rears its ugly head.
What can prompt a tech crash? Anything that threatens tech companies: harsh new privacy regulations, a rash of premature tech IPOs that fall flat at the same time, even the sudden downfall of an industry titan.
On the other hand, automotive stocks would generally be unaffected by these events, because auto is a separate industry with unique customers, laws, and trends. You become more diversified by owning stocks across many industries.
You become more diversified still by owning stocks from companies of different sizes: large cap, small & mid caps, international, etc.
Yet, you become the most diversified of all when you own entirely different asset classes, because they are even less correlated with one another. During a stock market crash, stocks plummet in value…but bonds increase, because investors start to seek safe returns again. The opposite is true during stock market booms: stock prices soar, while bond yields (generally) flatten.
If we could reliably forecast when booms and busts were going to happen, we could simply time our portfolios to own only the correct assets ahead of time and profit from what was about to take place. Many investors mistakenly believe they CAN do this.
They are wrong. All academic research shows that we have pathetically little skill at forecasting the overall market on a consistent, year in, year out basis with anything approaching reliable accuracy.
Therefore, the correct strategy is taking an “insurance policy” approach to investing, by owning several different types of assets that are not all highly correlated with one another. This way, even when some of your assets suffer, other assets prosper—helping to “even out” the damage inflicted by downturns, recessions, or just routine fluctuations.
The Importance of Getting it Right Up-Front
Before going into the nuts and bolts of asset allocation, I need to fully convey why it’s important to get this right now, before investing any money.
To continue the house analogy from part one: home builders focus almost obsessively on getting the blueprints right before buying a single nail or bucket of paint. Why? Because they have learned the time-honored saying “an ounce of prevention is worth a pound of cure” from hard experience. When you rush to get started on a large project without proper precautions, it becomes extremely messy, time-consuming (and, in some cases) impossible to reverse the mistakes that pile up.
Think back to the 2008 stock market crash that followed the real estate bust. How many stories were there about elderly people who lost their retirement savings in one fell swoop? The media used these stories to create doubts about the long-term viability of investing, essentially saying “see? this is what happens when you put your money in the stock market!” But in almost every case, the investors were failed by their asset allocation, not the market as a whole.
These elderly investors had aggressive asset allocations when they were young: which, as I explained earlier, usually means lots of their money invested in stocks. That’s great, and in fact, highly recommended for young investors, because they have time to take bigger risks and still come out ahead. But as these investors got older, they needed to shift more of their money into safer investments, to ensure it would be there when they needed it.
Had they done so, the 2008 crash would have merely hurt them a little. Instead, it completely wiped out a lifetime of retirement savings.
Still think asset allocation isn’t enormously and disproportionately important?
Three Asset Allocations Explained
Having laid that foundation, let’s get right into some example asset allocations and what they mean.
Here are some common examples from Allocation of Assets Info:
Within these broad asset classes, you might further specify the actual types of companies or funds you want to be invested in:
Depending on your sophistication and willingness to dive deep into investing, you could have an even more diverse allocation, such as this (from Wikipedia):
Again: this might seem like a luxury, something you can easily put off “until you have time” or “feel like dealing with it.” But recall how big of a mistake this can turn into. Of all the investors who lost their net worths in 2008, do you think any of them planned on it? Did a single one think about the risks, weigh out the pros and cons, and simply say “this doesn’t matter?”
Of course not. They all told themselves they would deal with it later—but when “later” came, it was already too late. You can’t afford not to get this right!
Also, if this is not clear to you by now, please realize that you do not simply pick one asset allocation and ride it out forever. Rather, you need to identify the correct asset allocation for your current situation, and then continuously re-calibrate it over the years to reflect your changing needs and circumstances.
In other words: if you are still investing the same percentage of your money into stocks, bonds, etc. five years before retirement as you were 30 years ago, you are in grave danger of losing everything. That’s why it is critical to gradually shift into a safer investment mix as you move through middle age and into retirement age.
As a hard-and-fast rule, you should own less stocks as you get older. By the time you are ready to retire, the vast majority of your money should be in bonds or other safe investment vehicles. There is a natural temptation not to do this, because (as we covered earlier in the book) bonds offer lower returns. Yet this is for a crucial reason: bonds are safer! When money is less likely to be lost, lower returns are the trade-off. Instead of resenting this or trying to tempt fate by getting higher returns, simply accept that this is a trade off you WANT to make at this stage of your life.
Failure to do so risks wiping out everything you spent decades working so hard to build.
Next week, I will close part three of this series with a discussion of rebalancing and risk vs. return in your asset allocation.