As we discussed last time, asset allocation is the most important investing decision you will ever make. Remember Roger Ibbotson, who said that asset allocation accounts for about 100% of performance. In this post I want to take a look at what asset allocation looks like from 50,000 feet. Hopefully this will give us some solid ground to stand on as we get deeper and deeper in the coming weeks. And with that….
At a high level, asset allocation is the amount of equity (stocks) vs. fixed income (bonds) that you hold in your portfolio. This is a risk based decision. The more equity you hold, the higher your risk and the higher your expected return. the more fixed income you hold, the lower your risk and the lower your expected return. So our first and most important decision is based on risk assessment and risk tolerance. We will have a post dedicated to those topics but understand that it’s all about managing risk. If you have a portfolio that is 60% stocks and 40% bonds, then your asset allocation is 60% equity and 40% fixed income. The easiest way to think about it is through the pie analogy. You start with a whole pie and your first decision is how to split that pie into the 2 large slices of equity and fixed income.
Next we have to split our large slices into smaller slices called asset classes. An asset class is an investment type underneath the equity or fixed income umbrella. Some of these asset classes are things like:
Equity Asset Classes
- Domestic Stock
- International Stock
- Large Cap (Cap = Capitalization, another way of saying Large Corporations)
- Small Cap (Small Corporations)
- REITS (Real Estate Investment Trusts)
- Sector Funds (Health Care, Energy, Financial, Technology, etc.)
Fixed Income Asset Classes
- Domestic Bonds
- International Bonds
- TIPS (Treasury Inflation Protected Securities)
- Municipal Bonds
- Treasury Securites
This list is not exhaustive but it gives you the idea and it is representative of the majority of major asset classes.
Once we have chosen which asset classes to include in our portfolio (which we will see from many industry experts later on) our pie looks something like this…
Lastly we must choose which mutual funds or ETF’s (For our purposes ETF’s are basically the same as a mutual fund. Think of an ETF as a mutual fund that is traded like a stock.) we will use to fill up our asset classes. For this step, our decision is relatively easy. We will choose a low cost index fund to match our chosen asset class. For example:
The list above is mostly ETF’s simply because ETF’s have no minimum investment. These ETF’s have similar or even lower, in some cases, expense ratios and have the same index fund characteristics of their mutual fund counterparts. The mutual funds through Vanguard typically have a $3,000 minimum investment.
So there we go… asset allocation is simply the 3 steps of…
- Choosing the allocation of Equity/Fixed Income
- Choosing the Asset Classes to make them up
- Choosing the Mutual Funds/ETF’s to align with the asset classes
Hopefully by now you see that asset allocation is not some complicated, algorithmic, regression analysis that is only possible for financial advisors or finance gurus. Anyone can do it with the proper education, thought and self-awareness. The question you should now be asking is ‘How should I answer those questions?’ Which we will get to starting next time when we discuss some things to consider when coming up with your own risk assessment.