A few years ago, a reporter interviewed me for an article she was writing. One question was “What is your recommended portfolio allocation given current market conditions?” My boring but truthful answer was that investment strategies should depend on individual situations, and that everyone is different. Like most media sources she was interested in the more exciting short‑term angle instead – my prediction for how certain markets would perform during the next 12 months. None of my quotes were used in her article, to no surprise.
Asset allocation is your investment snapshot from a broad perspective – how much you own each of stocks, bonds, cash, real estate, private investments and any other “alternative” assets. A common phrase we hear is “risk equals return”. When you invest in more volatile asset classes, the expected return is higher so that you are compensated for the extra uncertainty you are holding. And vice-versa.
One good thing about investing is that there is a good match for just about every situation. This is where asset allocation comes in. If you need to buy a car next week, owning a high-flying tech stock is probably not a wise idea with that money, but you can hold cash in your checking account instead. As the time horizon for using your money gets longer, your ability to take more risk and earn higher returns increases. Compartmentalizing your asset allocation into buckets based on your time horizon might look something like this:
- Short-term expenses within 12 months, or an “emergency fund”: FDIC‑insured bank accounts or Treasury bills
- Cash-flow needs between 1-10 years: High-quality short‑to‑intermediate-term bonds, which have higher expected returns than cash or T-bills, but tend to have slightly higher volatility
- Longer-term: Stock markets – the portion of your portfolio expected to give higher returns over time, but higher volatility in the short term
Periodic rebalancing is an important consideration. Without it, the risk of your portfolio could change from its original target. This is especially true right now. The global stock markets gained about 27% in 2019. A 60% weighting toward global stocks at the beginning of 2019 might be closer to 65% now as a result. Put another way, rebalancing is nice way to lock in some gains and forces you to “buy low and sell high”.
Finally, how you feel emotionally about risk and volatility is equally as important as what your time horizon would indicate you should do. Even if you have the ability to take a certain amount of risk, your gut feelings might not be consistent with that. Holding an asset allocation that you will be comfortable with when times are both good and bad is extremely important because it will help you avoid making changes based on emotion, which can lead to potentially harmful results.
Our brains are wired to remember recent events more than things that happened in the distant past. After a year where account balances increased sharply, it is natural to feel confident that we will continue to have good times going forward. Maybe we will. But it takes some effort to remember when the last time the markets were in turmoil. It will happen again, and the timing will be uncertain. Historically over the last century or so, the S&P 500 index has experienced calendar year returns in the range of -43% to +54%. Any time is a good time to ask yourself this question: How much of a dollar decrease on paper would I be okay with over the next 3-5 years?