Back To Basics #2: Asset Allocation
Last month, I started a new series of monthly articles called “BACK TO BASICS.” Each month, we will examine one of the basics of financial planning. This month, let’s look at asset allocation:
When it comes to investing, there’s a lot of terminology and jargon you might see bandied about by financial professionals or the media. Most of these terms are not hard to understand — but they may seem baffling at first glance. Understanding some basic investing terms is helpful because it can help transform investing from some arcane art into a simple process, and the more you see investing as a process based on rules and logic rather than something based on emotions, the more likely you will find success. Improper asset allocation is one of the most common mistakes an investor can make. Why is asset allocation so important? Look at it this way: If you were to eat only one type of food every day for your entire life, your body would be very unhealthy. If you were to exercise only one group of muscles for your entire life, your body as a whole would be very weak. And when you invest all your money in the same way, the same could be true of your finances. Asset allocation is basically a strategy that spreads your investments across different “asset classes.” The three main classes are equities (stocks), fixed income (bonds), and cash. There are other classes, of course, like commodities and real estate. And there are sub-classes as well. For example, stocks can be divided into many different classes, like international stocks and small-cap, mid-cap, and large-cap stocks, etc. The thinking behind asset allocation is that by mixing your investments across these different classes, you take on less risk. That’s because if one class goes down in value, the other classes you’ve invested in can compensate. Here’s an example of why asset allocation is so important. Let’s say that in Year 1, the stock market goes through the roof, so you put all your money into stocks. But in Year 2, the stock market performs poorly. It’s possible you could end up losing a lot of money. One important term every investor shoulder understand is “asset allocation.”
Now let’s say that instead of putting all of your money into stocks, you put 50% into the bond market. When the stock market went down, investors started pouring their money into bonds, causing bond prices to go up. That means that even though your stock holdings decreased in value, your bond holdings increased, meaning you could still break even or possibly come out ahead. Of course, this is a very general, simplified example. I’m certainly not recommending you do anything like that. (I would never recommend any particular investment or strategy to anyone without first sitting down and learning more about their goals, needs, challenges, and fears.) But hopefully it illustrates this point: Putting all your eggs in one basket is rarely a good idea.
While allocation is very important, it is but one part of what can be a very complex puzzle. Asset allocation is the colorful little pie chart that you see on your 401(k) statements. It looks something like this:
The other part of the equation is rebalancing. Rebalancing is the periodic adjustment to the account to bring the particular investments back into a predetermined range that is sometimes linked to your risk tolerance. This act of rebalancing keeps you from having too much of your growth in one sector (or stock) in case that sector (or stock) turns from being a winner to becoming a loser, as is often the case. So rebalancing keeps your pretty pie chart looking the same instead of having too much of one color. As if this is not enough to think about, in the modern investing environment with rising interest rates, historically low taxes, and historically high government debt, a prudent investor should be looking at allocation in how the accounts are treated from a tax perspective. But that is a subject for a different article. Next month, we’ll continue the series by looking at another important investment term everyone should understand. In the meantime, have a great month!
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