“The most important key to successful investing can be summed up in just two words − asset allocation.”
—Michael LeBoeuf, American business author
Although you might not be an experienced investor, you may already be aware of some important investing principles from your real-life experiences. For example, have you ever noticed that street vendors sometimes carry seemingly unrelated products such as sunglasses and umbrellas? Why? A customer is unlikely to buy both at the same time, but that’s exactly the point. These vendors are aware that on sunny days, sunglasses are likely to be in demand but on rainy days, people want umbrellas. By selling both products, vendors can diversify their product line and reduce the chance of low sales on any given day. Another example is the wide menu choice in a diner. If these examples make sense, you’re well on your way to understanding the fundamental investing principles of asset allocation and diversification. In fact, asset allocation is the easiest way to diversify a portfolio.
“Diversifying across many investments that are dissimilar and rebalancing those investments to their original target at the end of the year can reduce the annual volatility of the portfolio over time by enough to increase the compounded return.”
Richard A. Ferri
This chapter begins by examining asset allocation and diversification followed by a discussion of portfolio rebalancing. Savvy investors must be knowledgeable about these topics because they are essential to building wealth over the long run. However, this process takes time and dedication. Don’t expect to become a financial expert or to make a fortune overnight. Patience is a virtue when it comes to investing.
An asset class is a group of assets or securities that exhibits similar characteristics and behavior in the marketplace and is subject to the same laws and regulations. Asset allocation is dividing your investment dollars across different asset classes. Once you’ve implemented the asset allocation, you have created a portfolio, which is a collection of financial or real assets.
The main goal of asset allocation is to minimize risk while meeting an expected level of return. Thus, placing part of your money into different types of investments can help you when some investments don’t perform well. By diversifying into multiple asset classes you avoid concentrating your investment in a single area. Although financial experts often disagree on the exact allocations that investors should follow, they generally agree that the asset allocation decision has the greatest impact on the long-term performance of a portfolio. In fact, studies show that asset allocation is much more important than market timing and security selection in contributing to your portfolio’s overall returns. You can reduce your risk of losing money because the investment returns of each asset class move up and down under different market conditions. For example, market conditions may lead one asset class such as stocks to perform well while the returns on other categories such as bonds and cash equivalents are average or poor. Historical evidence indicates that the returns of stocks, bonds, and cash typically don’t move up and down at the same time. However, the correlation or association between the returns on stocks and bonds has varied widely over the last century and is sometimes strongly positive. Thus, diversification has not always provided the same level of benefit at different times in history.
“The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation.”
Tony Robbins
Where should you invest your money? Every investor must answer this profound question. Unfortunately, no simple formula is available to identify the right asset allocation for every person. Hence, asset allocations are highly personal and depend on such factors such as your financial goals, time horizon, and risk tolerance. Despite this fact, financial professionals stress that asset allocation is extremely important.
Although investors face many investment opportunities, they can be separated into two broad types: traditional and alternative investments. Traditional investments consist of the three most common asset categories: (1) stocks or equities, (2) bonds or fixed income, and (3) cash and cash equivalents, which are mainly short-term debt instruments. You can further subdivide these individual asset classes in other ways. For example, stocks can be differentiated based on size (e.g., large cap, mid-cap, and small cap) or industries (e.g., retail, financial, and manufacturing). Cash and cash equivalents include checking accounts, savings accounts, certificates of deposit (CDs), Treasury bills, money market deposit accounts, and money market funds. With these well-known investments, savvy investors can build their wealth over time through dividends, interest, and capital gains.
Below is an example of a portfolio diversified across three major categories using a mix of 50%/40%/10% among stocks, bonds, and cash, respectively.
Stocks (50%)
Small-cap growth stocks: 25%
Large-cap value stocks: 15%
International stocks: 10%
Bonds (40%)
Corporate bonds: 25%
Government bonds: 15%
Money market securities: 10%
Because traditional investments have varying levels of risk and return, they exhibit different behaviors over time. Thus, if you’re new to investing, traditional investments are a great place to start. If you invest in anything outside of the three traditional assets, you’re making an alternative investment, which includes a broad range of investments such as real estate, hedge funds, private equity, commodities, and infrastructure. Some types of alternative investments such as hedge funds aren’t readily available to most individual investors because of various restrictions on owning them.
Because traditional and alternative investments have important differences, you should carefully consider both the pros and cons of each investment option before investing to determine what’s right for you. Let’s examine a few differences between these two types of investments.
Liquidity. A key difference between traditional and alternative investments is liquidity, which is the degree to which an asset or security can be quickly bought or sold in the market without affecting its price. You have easy access to your funds placed in stocks and bonds that trade in highly liquid public markets. In contrast, many alternative investments such as real estate, hedge funds, and private equity are illiquid. That is, you’re unable to sell quickly because of a lack of buyers or restrictions placed on the investment. Furthermore, because most alternative investments are not publicly traded, their current prices are not readily available. Nonetheless, some publicly available alternatives like mutual funds, ETFs, and real estate investment trusts invest in certain types of alternative assets and provide the benefit of daily liquidity to investors.
“Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options.”
Joel Greenblatt
Risk and return. You may have heard the expression “no pain, no gain.” This phrase sums up the relation between risk and return. Risk drives returns. More specifically, risk drives expected returns since returns are not guaranteed. Each asset class has a different level of risk and return. For example, placing investment funds in cash equivalents involves low risk but your gains are also small, especially when interest rates are low. In addition, you face the risk of not meeting your financial goals and the problem of inflation outpacing and eroding investment returns over time. Investing in high-quality bonds is relatively safe and offers higher expected returns than cash equivalents. The stock market can be risky but generally offers higher returns than other traditional investments over time. Think about stocks as the “heavy hitters” − they can hit home runs but can also strike out. Historically, risk increases from holding cash to bonds to stocks. As such, expected returns also increase from cash to bonds to stocks. But this past relation may not repeat in the short term. That is why bonds and stocks are risky.
Alternative investments sometimes deliver even higher average returns over the long run but are generally riskier than traditional investments. Thus, some investors may want to include alternative investments within their portfolios. Be advised, however, that returns for both traditional and alternative investments can be volatile. Thus, you can lose some or all of your money during tough market periods.
Minimum investment and fees. Compared to alternative investments, traditional investments typically have lower minimum investment sizes and lower fees. For example, you can open a brokerage account with $1,000, but many hedge funds require a minimum investment of $1,000,000. If you’re a new investor or don’t have much money to invest, the smaller minimums could be important. Fees can be substantial especially for many alternative investments. Higher fees reduce your return over time.
Regulation. Traditional investments in public companies issuing stocks and bonds are subject to greater regulatory oversight and are less vulnerable to fraud than some alternative investments. Thus, traditional investments offer a higher level of security than alternatives due to their stricter regulation and greater transparency. Therefore, investing in alternative assets requires additional investor due diligence, which simply means doing your homework before undertaking a specific investment.
Given the differences between traditional and alternative investments, is one better than another? There’s no definitive answer to this question because the response depends on how you want to invest and what characteristics appeal to you. The decision may depend on how much liquidity you require, how much risk you’re willing to bear, how much money you have to invest, and your comfort level with the level of regulatory oversight of your investments. Consequently, you should carefully consider all your options before making any investment decisions. Keep in mind, however, that alternative investments don’t take the place of traditional assets – they’re complements, not substitutes. Therefore, you’re not necessarily making an either/or type of decision. Having both types of investments in your portfolio can be beneficial to building wealth. As a general rule, alternatives should constitute no more than 20% of a diversified portfolio.
“Hedge funds, private equity and venture capital funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets. But as their role has grown, so have the risks they pose.”
Jack Reed
If you’re new to investing or unsure about alternative assets, the logical starting point is to begin with traditional investments in building your portfolio. Most novice investors should leave investing in alternative investments to more experienced investors such as the professionals. After you become a savvy investor, adding alternative investments to your portfolio can be a powerful tool to help you achieve greater diversification, dampen volatility, and boost returns.
Asset allocations can range from highly conservative to highly aggressive. Your personal situation plays a large role. As you move through the various stages of life, you’ll need to change your asset allocation strategy to reflect your changing circumstances.
Financial goals. Your asset allocation depends on your financial needs and goals. Your goals could range from preserving capital, generating income, building long-term wealth (growth), or balancing income and growth. For example, keeping money in cash is generally reserved for meeting near-term spending needs and keeping an emergency fund. For many financial goals, investing in a mix of traditional assets is a good strategy.
Time horizon. Time horizon refers to the amount of time available to achieve a particular financial goal. Generally, the longer your time horizon, the more comfortable you’re likely to feel about taking risk. The Motley Fool, a financial information firm and website, offers several guidelines for asset allocation depending on when you need your money.
If you need the money within a year, you should keep it in cash and cash equivalents. Here your main concern is preserving your principal. Placing money in stocks and bonds could be foolhardy due to market volatility. For example, if your financial goal is to save for a summer vacation, pay for upcoming college tuition, or save for a down payment on a house, you should place your funds mainly in a savings or money market account. A savings account is a bank account that allows you to deposit money, keep it safe, and withdraw funds at any time, while earning interest. A money market account is an interest-bearing account that usually pays a higher interest rate than a savings account and provides the account holder with limited check-writing ability.
If you need the money within the next 1–5 years, you should select safe, income-producing investments such as Treasuries, CDs, and investment-grade corporate bonds. Your main objective is to generate income as is typical of those nearing retirement. US Treasury securities such as bills, notes, and bonds are debt obligations of the US government. Treasuries have very low credit risk but are affected by other types of risk, mainly interest-rate risk and inflation risk. A CD is a type of federally insured savings account that has a fixed interest rate and maturity date. CDs can offer higher rates than standard savings accounts, but the cash isn’t as accessible. A corporate bond is a debt security issued by a corporation and sold to investors. Chapter 3 focuses on the bond market.
“An asset allocation plan is based on your personal circumstances, goals, time-horizon, and need and willingness to take risk.”
Michael LeBoeuf
If you don’t need money for more than five years, you should consider investing in stocks. Remember from Chapter 2, a stock is a security offering ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. Over the long term, stocks offer higher expected returns than other traditional assets but with greater risk. Historically, your likelihood of earning a positive return by holding stocks increases with the length of your holding period.
Return needs. Another factor influencing your asset allocation is your return needs. As previously mentioned, stocks generally provide higher returns than bonds and cash over time, but the year-to-year variations in returns can be substantial. Given that most investors don’t have reliable crystal balls to evaluate future returns, they often use past returns as a starting point for estimating the returns on different asset classes. You should consider your returns after taxes to provide a more useful comparison between different types of investments. To reduce the impact of taxes on your returns, you may be able to place your money in tax-exempt accounts such as pension plans, individual retirement accounts (see Chapter 6), and municipal bonds.
Risk tolerance. Risk tolerance refers to the degree of variability in investment returns that an investor is willing to withstand. In other words, risk tolerance is how much risk you are willing to take regarding your investments. As your risk tolerance increases, you become a more aggressive investor and should allocate a greater percentage of your portfolio to stocks. Conversely, the lower your risk tolerance for enduring portfolio ups and downs, the more your portfolio should be allocated to bonds and other conservative investments. According to William Bernstein’s The Intelligent Asset Allocator, if you can’t tolerate a 20% drop in value in your portfolio, you shouldn’t invest more than 50% of your money in stocks.
You may have heard of the proverb that “A bird in the hand is worth two in the bush.” This means that having the certainty of a small return is better than the possibility of a greater return, which may not occur. Thus, conservative investors keep a “bird in the hand” by having low-risk investments, while aggressive investors seek “two in the bush” by owning higher risk investments.
“The problem with long-term investing is the short term. Nothing destroys a good long-term plan like extreme short-term volatility. That throws people off track, and they often do things that are emotional rather than rational.”
Richard A. Ferri
Age. Your risk tolerance is often closely related to your age and can help to determine what type of investments you’re likely to make. Risk tolerance generally changes over an investor’s lifetime. For example, younger investors can generally bear more risk and hence can be more aggressive investors because they have a longer period to recoup losses than older investors approaching retirement. Investors who have a high risk tolerance normally allocate a higher percentage of their portfolios to stocks. As investors age and their investment horizons shorten, they usually transition their portfolios toward less risky and less aggressive asset allocations. As people approach retirement, they generally shift their portfolios toward lower risk and more conservative allocations to help protect the assets they’ve already accumulated and to generate income. Thus, the asset allocation of older investors who have a low risk tolerance should be weighted more to safer, income-producing investments such as bonds, CDs, and savings accounts. However, such an allocation strategy assumes intergenerational wealth transfer is not an important goal and an investor is considering only his or her lifetime with no bequests. If the investor anticipates transferring wealth to future generations, then the portfolio should still hold more risky investments.
When investing in traditional assets, your biggest decision involves how much of your portfolio you should allocate to stocks, bonds, and cash. At first glance, this asset allocation seems easy because you’re only dealing with a few asset classes. In practice, this isn’t so simple. Here are several asset allocation strategies.
Age-based asset allocation bases the asset allocation on the investor’s age. According to one popular approach, the stock investment decision is based on deducting your age from a base value of a 100. Other financial professionals, however, suggest using a base value of 110 or 120 depending on your life expectancy or risk appetite. The higher the life expectancy or risk appetite, the higher the portion allocated to stocks. Thus, a person with medium risk tolerance would use a base value of 110 while someone with high risk tolerance would use 120 as the base value. For example, let’s assume you’re 45 years old with a medium risk appetite. As a general rule, you would subtract your age from 110, indicating that you would invest 65% ( = 110 – 45) of your portfolio in stocks with the remaining portion 35% in bonds.
Age-based asset allocation is a simple rule of thumb based on the “average” investor. It assumes that younger investors can be more aggressive and hold a larger portion of their portfolios in stocks because they can weather the volatility of owning stocks over a long time horizon. As they age, their portfolio’s mix of stocks and bonds becomes more conservative as the balance gradually shifts as the percentage of stocks decreases with a corresponding increase in bonds. Some limitations with this rule are that it assumes investors are average and ignores personal circumstances.
Strategic asset allocation (SAA) is a traditional approach to building a portfolio. With SAA you determine a base policy mix of investments and periodically rebalance to get back to the original mix. This procedure maintains a long-term goal for asset allocation. SAA’s primary goal is to create a base asset mix that seeks to provide the optimal balance between risk and expected return for a long-term investment horizon.
“You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.”
Ray Dalio
Like any strategy, SAA has both pros and cons. SAA is appropriate for long-term investors who want an investment mix that remains the same regardless of market conditions. It’s relatively easy to implement and maintain. It can also be low cost and tax efficient due to infrequent buying and selling. Additionally, SAA is tailored to the individual investor’s profile. Thus, it’s an unexciting but generally effective type of buy-and-hold strategy suitable for those who don’t want to engage in trying to time markets or make specific security selection. The chief cons of SAA are that it only focuses on an investor’s profile and doesn’t make adjustments for changing economic or market conditions. Therefore, it can underperform market benchmarks in bull markets and quickly drop in value in bear markets.
Tactical asset allocation (TAA) is a dynamic investment strategy that actively adjusts a portfolio’s asset allocation during the short to intermediate term. Unlike SAA, which is relatively rigid over the long run, TAA permits short-term, tactical deviations from the original mix to capture superior returns due to anticipated shifts in market fundamentals, opportunities, or risks. Hence, TAA is driven by market events and adds a market-timing component to the portfolio. After achieving the desired short-term profits, TAA returns to the overall strategic asset mix. Thus, the goal of a TAA strategy is to improve the risk-adjusted returns of passive investment management.
“The most important thing you can have is a good strategic asset allocation mix. So, what the investor needs to do is have a balanced, structured portfolio – a portfolio that does well in different environments…. we don’t know that we’re going to win. We have to have diversified bets.”
Ray Dalio
Although enhancing returns seems attractive, TAA is more difficult to implement than SAA because it requires moving in and out of the market at the right time. That is, you need to predict the future with accuracy and then act on your expectations at the appropriate time. In practice, market timing is extremely difficult to do successfully. You’re as likely to reduce your returns as to enhance them. Additionally, buying and selling more frequently can have negative tax consequences and result in higher brokerage fees. So, the risks and costs associated with TAA are unlikely to outweigh its benefits for the vast majority of individual investors.
“It is not prudent to attempt to switch and swap asset classes based on short-term market predictions.”
Richard A. Ferri
Dynamic asset allocation (DAA) is another active allocation strategy that frequently adjusts the mix of assets as markets or certain securities rise and fall. Therefore, you reduce the weights of assets with poor performance by selling them and simultaneously increase the weights of assets with a strong performance by buying them. This highly flexible approach can possibly provide higher portfolio returns by adjusting to market changes and market risk if you have the requisite knowledge and skill to identify evolving market trends. However, frequent buying and selling can increase transaction costs and reduce returns. Using this strategy is best left up to professional portfolio managers, not novice investors, because of the expertise and talent required. Savvy investors know their own limitations.
Insured asset allocation is a strategy that involves establishing a base asset value or floor for the portfolio. As the portfolio value approaches the base value, an investor can take actions to avert further portfolio declines like buying risk-free assets, such as US Treasuries, to stabilize the base value. If the portfolio remains above the base value, an investor can engage in active management to increase the portfolio value. As a result, an insured asset allocation strategy is well-suited for risk-averse investors who not only want to engage in active portfolio management but also want the security of having a specified floor value of a portfolio. For instance, an insured asset allocation strategy could be attractive to investors who want to maintain a minimum standard of living during retirement.
Various online asset allocation tools are available for helping you make these decisions. Be advised, however, that if you use several different online asset allocation tools, you’ll probably get somewhat different recommendations because each tool uses a different set of assumptions. Nonetheless, sampling some of these tools is a good way to start your analysis in building a balanced portfolio. You should also be aware that your perception of their risk tolerance is important, which some of these tools provide you help to identify. Each asset allocation calculator should get you in the right ballpark.
Advisorkhoj.com provides an asset allocation calculator based on your age, risk level, and time horizon (https://www.advisorkhoj.com/tools-and-calculators/asset-allocation).
Bankrate.com offers an asset allocation calculator designed to help create a balanced portfolio of stocks, bonds, and cash based on factors such as age, ability to tolerate risk, and economic outlook (https://www.bankrate.com/calculators/retirement/asset-allocation.aspx).
CalcXML.com provides a calculator to help determine your portfolio allocation based on your propensity for risk (https://www.calcxml.com/calculators/inv01).
Money.cnn.com has a calculator that provides the mix of different types of securities to help you determine whether you will reach your goals (https://money.cnn.com/tools/assetallocwizard/assetallocwizard.html). It also offers various retirement calculators.
Personal.Vanguard.com provides an investor questionnaire that suggests an asset allocation based on your answers to questions about your investment objectives and experience, time horizon, risk tolerance, and financial situation (https://personal.vanguard.com/us/FundsInvQuestionnaire).
RealDealRetirement.com provides tools, calculators, research, and other resources to help you with all aspects of retirement planning (https://realdealretirement.com/toolsresources/).
SmartAsset.com offers an asset allocation calculator that helps you tailor your allocation to stocks, bonds, and cash to align with your risk tolerance: very conservative, conservative, moderate, aggressive, and very aggressive (https://smartasset.com/investing/asset-allocation-calculator#W2oO5SjZih). The website also provides a free tool that matches you with up to three advisors who can provide expertise based on your specific goals.
You can avoid the hassles involved in developing an asset allocation by using an asset allocation fund, which is a fund that provides investors with a diversified portfolio of investments across different asset classes. Various investment companies such as Fidelity Investments and T. Rowe Price manage different types of these funds. The most basic type of fund is a balanced fund, which implies a balanced allocation of equities and fixed income. Other types include target-date funds (TDFs), funds designed to maintain a specific asset allocation ranging from conservative to aggressive, and funds managed in anticipation of specific outcomes, such as inflation. Let’s illustrate an asset allocation fund by looking at a TDF in more detail.
A TDF, also called a life cycle fund, is a pooled investment vehicle (PIV) whose asset allocation mix becomes more conservative as the target date approaches. The target date is intended to represent the date that you plan to retire or start withdrawing funds. The portfolio’s composition gradually transitions from higher risk stocks to lower risk bonds and cash equivalents. This shift provides the potential for long-term growth and guards against the market’s downside as the target date gets closer. Most TDFs are basically a fund of funds that invests in other mutual funds or ETFs. A fund’s name often refers to its target retirement date such as “Retirement Fund 2040” or “Target 2050.” A fund’s marketing materials typically provide the allocation glide path, which is the shift of assets across the entire investment time horizon. TDFs are frequently available through retirement plans such as 401(k) plans, as discussed in Chapter 6, and are often the “default investment.”
As with any investment, TDFs have both advantages and disadvantages, but the pros outweigh the cons.
Pros. The main selling point of a TDF is convenience. This all-in-one vehicle offers a diversified portfolio and an autopilot way to invest. Although TDFs provide a simple solution to asset allocation, don’t assume that all TDFs are the same. Funds with the same target date may have different asset allocations and allocation transition paths.
Cons. TDFs can be expensive and involve higher expenses than other passive investments. They also don’t guarantee income and may not provide a sufficient inflation hedge. However, some TDFs invest in Treasury Inflation-Protected Securities (TIPS) and real estate, which traditionally have helped hedge against inflation. TDFs are unable to accommodate an individual’s changing goals and needs or consider other investments or sources of income. Thus, you shouldn’t view a TDF as a “set it and forget it” investment. Instead, you should reevaluate the TDF every five years or so to see if continuing to hold it still makes sense given your current situation.
In summary, asset allocation funds offer a “one-size-fits-all” solution, which may be good enough for the average investor who doesn’t have the time or expertise to build a diversified portfolio. For example, Fidelity Investments manages different types of these funds that are managed to a specific target date, to maintain a certain asset allocation, to generate income, and to hedge specific outcomes such as inflation.
Although many asset allocation strategies and models are available on the internet and elsewhere for the do-it-yourself investor, broad consensus exists among financial experts about the basic guidelines of asset allocation. Below are some of these guidelines for “typical” investors.
Allocate a larger portion of an investment portfolio to stocks as the investment horizon increases. Both individual stocks and overall markets can have both good and bad years. The longer the investment horizon, the greater the chance that the good years outweigh the bad ones.
Keep at least some portion of an investment portfolio in stocks regardless of age or risk tolerance. Including stocks in a portfolio provides diversification and improves total returns over time.
Diversify within the stock portion of the portfolio. Diversifying stocks by size as measured by market capitalization, investment style such as growth and value, and geographic location can improve a portfolio’s risk–return trade-off.
Place more weight on small stocks, growth stocks, and international stocks when younger and more emphasis on large-cap stocks and value stocks when older. Younger investors can usually tolerate more risk than older investors due to their longer time horizon.
“Every portfolio benefits from bonds; they provide a cushion when the stock market hits a rough patch. But avoiding stocks completely could mean your investment won’t grow any faster than the rate of inflation.”
Suze Orman
Mix stocks with bonds and cash to moderate portfolio risk. Generally, the returns of stocks, bonds, and cash don’t all move up and down at the same time. As a result, portfolio risk decreases by combining traditional asset classes in a portfolio.
Shift the bond portion of the portfolio from long-term bonds to intermediate-term or short-term bonds as an investor’s time horizon shortens. Shortening the bond maturity leads to more stable bond prices resulting in lower risk.
Increase the proportion of bonds and cash in the portfolio as an investor’s time horizon shortens. Moving toward assets with more stable prices lowers risk resulting in a more conservative portfolio.
Although these guiding principles primarily apply to “typical investors” for their age, your needs may differ due to your risk tolerance, special circumstances, and other factors. Consequently, you may need to do some tweaking to get a more appropriate asset mix.
“The enemy of a good asset allocation is the quest for a perfect one. Fight the urge to be perfect.”
Richard A. Ferri
The answer to this question is “it depends.” This might not seem helpful but a “one-size-fits-all” asset allocation doesn’t fit everyone! There’s no perfect or best asset allocation strategy, only one that’s right for you and your specific situation. Determining the appropriate asset allocation depends on picking an asset mix that makes you feel comfortable and offers the best chance of meeting your financial goals based on a specific risk level. You have several major ways to develop an asset allocation.
Use a model portfolio or online asset allocation tool.
Invest in an asset allocation fund such as a TDF.
Use an investment advisor, robo-advisor, or broker.
Build your own allocation model.
Each of these asset allocation approaches has strengths and weaknesses. The approaches range from standardized to customized. If you’re someone who has relatively little investment knowledge and experience, you’ll probably find asset allocation funds particularly useful. Why? These funds are the simplest possible option. All you have to do is to pick a reputable fund such as Vanguard that matches your expected retirement date or asset allocation and the fund handles the rest. Savvy investors know when to go on autopilot.
“The conventional asset-allocation method is like sheet music. It is prescribed, it has right answers and wrong answers and it sounds about the same every time. But jamming is different. Jamming is when you make the music. When you improvise and adapt to conditions. When you are creative.”
John Kao
Let’s use an analogy. Most people drive cars with an automatic transmission, not a manual transmission, because these cars are much easier to operate. By analogy, a TDF is the automatic transmission of retirement plans. It automates the decision and eliminates the complexity of choosing different asset allocations and rebalancing a portfolio. Thus, TDFs are a good choice for a novice or even a “typical” investor. If you want to gain more control over your driving, you may want to switch to a car with a manual transmission and clutch. If you don’t select a TDF, another excellent choice is to follow an SAA strategy with rebalancing at least annually. As you gain more investing knowledge, skill, and experience, one of the more complex and nuanced asset allocation strategies may become more appealing because it’s customized to meet your needs. However, more active management approaches such as TAA and DAA involve market timing, additional fees, and possible tax payments that typical investors should usually avoid.
“Diversify. In stocks and bonds, as in much else, there is safety in numbers.”
Sir John Templeton
Investment professionals usually view diversification as one of the key tenets of investing. A well-diversified portfolio is the foundation of a smart investment strategy. Diversification is an investment strategy of spreading money across multiple asset classes and securities to limit exposure to any one asset type. The word itself makes many feel warm and fuzzy! You can diversify your portfolio using both traditional and alternative assets. Although diversification seems like a simple process, it isn’t. The trick is to find the proper balance in your portfolio (asset allocation) to achieve your financial goals. Finding the right level of diversification is a personal matter. You don’t want too little diversification, but you also don’t want too much. For example, having too many individual stocks can lead to extensive due diligence, a complicated tax situation, and performance that mimics the market. Too much diversification can lead to diworsification, a term coined by Peter Lynch in his 1989 book, One Up on Wall Street. Diworsification results from adding too many asset classes with similar correlations to a portfolio that worsens the risk–return trade-off. Thus, diversification is like eating chocolate. It’s good but only in moderation. To achieve adequate diversification, you need to (1) spread your portfolio among different asset classes, (2) stay diversified within each asset class, and (3) include assets or securities that vary in risk.
If constructed properly, diversification can improve returns for a given level of risk. Other important benefits of appropriate diversification are that it can help mitigate your portfolio’s risk and volatility as well as provide peace of mind. Yet, diversification can’t eliminate all risks, ensure a profit, or guarantee against loss.
A diversification strategy using asset allocation can help you achieve more consistent returns over time and reduce your overall investment risk. Still, a particular asset allocation model doesn’t necessarily lead to diversification and reduce risk unless it appropriately spreads an investment among various asset categories and securities. For example, investors who allocate 100% of their portfolio to large-cap stocks or to corporate bonds aren’t well diversified. Another common misconception is that increasing a portfolio’s diversification necessarily decreases its risk. For example, just adding more stocks to a portfolio that are similar to the stocks you already own is unlikely to reduce risk because whatever happens to one is likely to happen to others.
Most beginning investors are unlikely to go down the path of researching, selecting, and buying individual securities or investments such as stocks and bonds because they lack the expertise or time to do so. If you’re such an investor, you’re better off buying a diversified blend of low-cost mutual funds or ETFs that include US stocks and bonds and foreign shares before taking on more investments. For example, you can achieve sufficient domestic and foreign diversification by owning just three index funds: a total US stock market fund, a total US bond market fund, and a total international stock fund. Think about that – extremely efficient, low-cost global diversification with just three investments!
“Portfolio theory, as used by most financial planners, recommends that you diversify with a balance of stocks and bonds and cash that’s suitable to your risk tolerance.”
Harry Markowitz
If you want to choose your own investments, you probably don’t want to have too many. As a general guideline, if you need more fingers than are on both hands to count your investments, you may have too much overlap. As you now know, traditional assets consist of just three asset classes. Diversification is also possible within an asset class. For stocks, you can diversify by market capitalization, geography, and sector. For bonds, you can diversify by such features as maturity, credit quality, and tax status.
Investors can make several mistakes when diversifying or trying to diversify their investment portfolios. Having a properly diversified portfolio avoids these errors.
“Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.”
Philip Fisher
Under-diversification. You’ve probably heard the saying “Don’t put all your eggs in one basket.” In investing, this piece of sound advice means that you shouldn’t put all of your money into a single investment such as one stock or into several stocks in the same sector or industry because you could lose everything. You’re under-diversified! By holding too few investments, you may not have enough exposure to well-performing investments. Many factors could derail this investment strategy such as worsening economic conditions or increased competition. If the basket breaks, you lose all your eggs. Instead, you should spread your money across different types of assets and securities so that gains from some investments offset losses from others. Thus, if you omit major asset classes from your portfolio, you can’t classify it as diversified. Failing to look beyond traditional assets to alternative asset classes is also a form of under-diversification.
The underlying logic of a diversification strategy is that despite how the market performs, a portion of your portfolio is likely to do well. That is, you want to be in assets whose returns move in opposite directions. If you’re a beginning investor or one who doesn’t want to devote the time and effort required to thoroughly research and analyze investments, you should diversify for your own protection. That is, you want to protect yourself from the dangers of inadequate diversification.
“Obsession with broad diversification is the sure road to mediocrity.”
John Neff
Over-diversification. Over-diversification comes in several forms. One form is owning too many of the same or similar types of securities, mutual funds, or ETFs within your portfolio. For example, you could hold several different stock index funds that all have a similar market exposure to large company stocks such as the S&P 500 Index. By owning these three funds, you suffer from investment overlap, meaning you indirectly own the same securities multiple times in different investments. Hence, you’re incurring additional costs or fees by holding these similar funds without receiving any extra diversification. You need to peel back that next layer to see what’s actually in the fund. To avoid investment overlap, you should be able to explain why you bought each investment that you own.
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Warren Buffett
Another form of over-diversification occurs as you gain investing knowledge and skill. You don’t want to diversify away good ideas into meaningless oblivion. You don’t want to be overcome with the fear of having too few eggs in one basket. The problem with diversification is that despite enabling you to lessen losses with offsetting gains, the opposite is also true. If you over-diversify, you might not experience many losses, but you won’t hit many home runs either. Owning a little bit of everything is a recipe for mediocrity. However, if you’re willing to accept “average” returns through diversification, you’re likely to do better than most of the pros, over the long run, who are active investors.
Uneven diversification. Although the least common diversification mistake, some investors become too highly concentrated in just one or two asset classes when such concentration is inappropriate. This situation doesn’t refer to younger, more aggressive investors who want a high concentration of stocks to build their wealth or older, more conservative investors who have a high concentration in bonds to preserve their wealth. Instead, it usually occurs when investors fail to periodically rebalance their portfolios. That is, their target or desired asset allocation can get “out of whack” over time. For example, the stock portion of a portfolio may increase markedly during surging equity prices during bull markets. The key to avoiding uneven diversification is to engage in rebalancing, which is the process of realigning the weightings of a portfolio of assets. Through rebalancing you periodically buy or sell assets in your portfolio to maintain an original or desired level of asset allocation or risk. For example, you could rebalance once a year on your birthday, especially if you have a 401(k) plan with no direct transaction costs. This simple guideline is better than not doing it all. Don’t make the mistake of assuming that diversification is a one-time exercise.
Diversification works when assets react differently to the same economic event. That is, diversification provides benefits when you hold two or more assets whose values don’t rise or fall in synch. For example, stocks typically do better when the economy grows, and bonds and other fixed income securities do better when the economy slows.
“You can’t diversify your way out of a financial hurricane.”
Kenneth G. Winans
Diversification works best during a bull (up) market when you don’t need it. In theory, diversification of noncorrelated assets can reduce losses in bear (down) markets. Unfortunately, when markets are falling or crashing, diversification loses some of its benefits. That is, diversification is less efficient under extreme conditions. Why? In bear markets, historical correlations break down and the returns on assets tend to move more closely together. Thus, there’s a downside danger to diversification. When you need it most, the benefits of diversification are smaller and may even disappear.
“Wall Street’s graveyards are filled with men who were right too soon.”
William Hamilton
A common practice followed by savvy investors is to monitor, rebalance, and refresh their portfolios. As previously noted, using asset allocation to achieve diversification isn’t a “set it and forget it” proposition. Rather, you need to monitor your portfolio and periodically evaluate its performance and risk. You also need to revisit your asset mix to ensure that it’s still appropriate. If not, you should rebalance. Additionally, if your investment strategy or risk tolerance has changed, you should readjust the weightings of each asset class to match the new asset allocation.
“Consistently rebalancing your portfolio can help protect you from trading based on emotions.”
Marci McGregor
Rebalancing is the process of periodically realigning a portfolio’s weightings to bring the assets back to a desired allocation. Given market volatility, you can experience portfolio drift, which occurs when asset classes have differing intermittent rates of return. As a result, weightings tend to drift over time from their target allocations. You need to keep this drift or “risk creep” in check to reduce exposure to risk relative to the target asset allocation. Peter Lynch, a famous mutual fund manager, colorfully referred to this practice as “cutting the flowers and watering the weeds.” Rebalancing involves selling some of the assets that are doing well (the winners or flowers) and putting the proceeds into areas that are struggling (the losers or the weeds). This approach seems counterintuitive because investors don’t want to sell when the stock market is doing well or buy when it’s doing badly. However, rebalancing actually promotes good investment behavior. You’re really selling high and buying low, which is a sound investment principle.
Although rebalancing may seem boring, it’s a sound investment strategy that offers numerous benefits. You rebalance to keep a well-balanced portfolio, which can lead to higher long-run gains. Rebalancing can also prevent you from making the classic behavioral mistake of buying high and selling low. That is, it imposes discipline by helping you follow your investing plan despite what’s happening in the market. Additionally, rebalancing can protect you against an asset bubble, which is when an asset’s price becomes over-inflated. Rebalancing is the key to maintaining a specified risk level over time. Finally, you need to periodically refresh your portfolio to reflect any changes in financial conditions, lifestyle, and goals.
Because rebalancing is an important investing principle, you’ll need to have a strategy for reviewing your portfolio and deciding when to rebalance. Choosing an appropriate strategy generally depends on such factors as your personal preferences, transaction costs, and tax considerations.
Time approach. One time-tested method is to rebalance at a preset time interval such as quarterly, semiannually, or annually. However, using a time-only or periodic rebalancing strategy involves taxes, commissions, time, and effort. For example, rebalancing could result in capital gains, which are taxable.
Threshold approach. Another approach is to rebalance if an asset class drifts by a certain threshold, either in percent or percentage points. The costs of tolerance band rebalancing are higher when setting lower thresholds (1% or 1 percentage point) versus higher thresholds (5% or 5 percentage points).
Combined time-threshold approach. Of course, you can combine time markers and threshold targets. Using a time-threshold approach, you rebalance your portfolio periodically, such as semiannually or annually, but only if the asset allocation has drifted by at least a specified amount of say 5%. The time-threshold approach may produce an acceptable trade-off between controlling risk and minimizing costs.
Event approach. An event-driven approach rebalances after major market swings. Of these approaches, using arbitrary dates or thresholds alone to “robotically” rebalance is less effective than either using a combination of the two approaches. Preferably, you should time your rebalancing for periods when the markets’ trends seem to be reversing, which reflect the most opportune time to rebalance. Owning different asset classes and periodically rebalancing the portfolio to restore the initial allocation between classes reduces overall volatility and ensures a regular harvesting of portfolio gains.
Different ways are available to bring your portfolio back to your original asset allocation mix or to a new mix if your financial circumstances or risk preferences change. Here are three different ways to rebalance your portfolio if you’re doing the rebalancing yourself and not relying on an asset allocation fund such as a TDF to do it for you.
You can sell off investments from over-weighted asset categories and use the proceeds to buy investments for under-weighted asset categories. This approach is probably best if you have a 401(k) plan.
You can buy new investments for under-weighted asset categories.
If you continue to add to your portfolio, you can modify your contributions to allocate more investments into under-weighted asset categories until you’ve achieved the desired portfolio balance. This approach minimizes transaction costs and tax consequences by adding new money instead of liquidating existing assets.
Investors often make the following mistakes when rebalancing a portfolio.
Following a mechanical timeline when rebalancing. Deciding when to rebalance is a judgment call. There’s no optimal time. Instead, you should rebalance as often as the market or circumstances dictate and not be a robot to the rebalancing clock.
Ignoring transaction costs and taxes. Rebalancing too often can result in incurring high transaction fees and can trigger costly capital gains taxes. However, for tax-advantaged accounts, you can rebalance more often without worrying about taxes.
Failing to consider the prospects. Rebalancing involves selling a successful investment to buy something else. However, you need to evaluate the circumstances. You don’t want to sell a winner that’s still promising or buy an asset that’s likely to keep going down. As a litmus test, ask yourself the question of whether you’d buy the asset today. If the answer is yes, then keep it, if not sell it and find a more promising investment within the same asset class.
Savvy investors know that asset allocation, diversification, and rebalancing are critical to helping them meet their financial goals. Because no single model or strategy is right for achieving every financial goal, you need to find an approach that fits you. Here are some key takeaways from this chapter.
Spread your money among different asset classes to reduce your risk. Asset allocation has a major impact on whether you’ll meet your financial goals.
Don’t weight assets by their risk–reward proposition in isolation but by how each asset fits into an overall portfolio. The correlation between returns of various asset classes critically affects portfolio performance.
Match your asset allocation with your time horizon and risk tolerance. The longer the time horizon, the greater is your ability to take on riskier investments.
Adjust your asset allocation as your personal circumstances and risk tolerance change.
Avoid holding too few (under-diversifying) or too many (over-diversifying) investments in a portfolio.
Monitor, rebalance, and refresh your portfolio after establishing your desired asset mix.