Why asset allocation is THE most important consideration for an OD's investment portfolio

Natalie Schmook

April 19, 2020

Last Friday, I had the pleasure of sharing a webinar with practice owners about managing personal finances during COVID-19. You can watch it here (the password is e0&8A=3s). One of the things I talked about was the importance of asset allocation in developing your investment portfolio.

Asset allocation isn’t just important—it’s the biggest driver of return for publicly traded investments. Research shows that historically your allocation accounts for a whopping 88% of investment return. Now, past performance isn't a guarantee of future results, but I would argue that's a number worth paying attention to.

What is asset allocation?

Asset allocation is very simply the mix of asset classes in an investment account. Asset classes are categories like large cap (large company) stock, small cap (small company) stock, short term investment grade (high quality) bonds, long term investment grade bonds, real estate, etc.

Let’s say you manage your own portfolio and you have 25% in Apple stock, 25% in Amazon stock, 25% in Procter & Gamble stock and 25% in a REIT (real estate investment trust). Your asset allocation is 75% large cap stock; 25% real estate.

What does asset allocation mean for my investment returns?

As I mentioned before, the mix by itself has historically dictated almost 90% of the return. So if an asset class like large cap stock returned 10% last year, almost 9% of that return just because you owned large cap stock (no matter which ones) and the remaining ~1% was a function of the individual investments.

This is one reason index investing (purchasing an index like the S&P 500 or Russell 2000) is so popular. Many investors and investment managers would rather take the 88% return the broader asset class (like large cap stock) offers and eliminate the upside- or downside- the remaining 12% might hold for individual investments.

Professional investment advisors look at asset allocation in terms of risk and return. Consider this portfolio of 50% Asset Class A, 50% Asset Class B:

*If you’ll remember back to your collegiate statistics class, 99.7% of returns fall within 3 standard deviations

As an investor develops their portfolio, two questions matter: is the expected return enough to help them meet their long term goals, and, can the investor stomach the downside risk?

What’s the right asset allocation for me?

Now is actually a perfect time to think about your asset allocation because there’s so much uncertainty and volatility in the market. If you’re excited about investing more money right now even though your portfolio is down, you’re probably a higher risk investor. If you’ve thought about selling investments because the market still might go down more, you should probably consider a lower risk portfolio.

One bonus I offered on last week’s webinar (password is e0&8A=3s) is a free risk assesment to help you develop your personal asset allocation. This is what I use with my clients and is one of the main components of their retirement planning. If you didn't have a chance to sign up for the webinar to get this free tool, just reply to this email and ask me to send you the risk tolerance questionnaire.

What about the age-based rule?

You may have heard that your mix of stocks and bonds should be based on your age. So if you’re 50, 50% of your portfolio should be in stock-like investments and 50% should be in bond-like investments.

The problem this rule of thumb is 3-fold:

a) It assumes everyone is retiring in their 60s, which isn’t always true

b) It doesn’t consider underfunding (or overfunding) of retirement savings, both of which have different investment approaches

c) There is no consideration to how an investor feels about the performance of their portfolio. Typically investors work hard for the funds they put into the market—they deserve to have a say in the risk profile

In Summary

If you’ve never thought about your asset mix for investments, now is a good time to think about it. On any given year, 88% of your investment return is usually determined by the asset mix, not the actual investments. And managing your portfolio to your specific risk profile is a great way to avoid making bad timing decisions with your portfolio.

FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY.

The views expressed here are as of the date of publication and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer (or recommendation) Hayes Wealth Advisors to sell or provide, or a specific invitation for any investor. Information herein may have been obtained from sources believed to be reliable, Hayes Wealth Advisors is unable to warrant its accuracy.

All data, projections and opinions are as of the date of this report and subject to change.

Investing involves risk, including the possible loss of principal. Past performance is no guarantee of future results.

Hayes Wealth Advisors does not provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. All recommendations must be considered in the context of an individual investor’s goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be suitable for all investors.

Investments have varying degrees of risk. Some of the risks involved with equity securities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government. Investments in foreign securities (including ADRs) involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration.