Asset allocation is one of the most boring topics on earth. Bring it up in polite conversation or in front of a group of workshop participants and it won’t be long before eyes glaze and an epidemic of yawning breaks out.
That’s too bad because it’s also one of the most important — and misunderstood — topics for successful investing.
Your most important investing decision
Asset allocation is easy enough to define. It refers to how your portfolio is divvied up among asset classes, particularly stocks and bonds. Determining your optimal asset allocation has mostly to do with your investment time frame and your risk tolerance.
Numerous academic studies have come to a very counterintuitive conclusion: Making sure your portfolio is allocated properly — meaning, it contains the proper mix of stocks and bonds for someone of your age and with your comfort level with risk — is more important to your investing success than the actual investments in your portfolio.
But here’s the kicker. According to a study by Prudential Investments, 42 percent of investors don’t know how their portfolios are allocated. And my guess is the actual percentage is even higher, given how few people seem to know what asset allocation means.
So, here’s my question: Do you know how your portfolio is allocated? Could you describe its asset allocation in a brief conversation?
Is your portfolio off target?
If your only investment is a target-date fund held in a 401(k) plan, you may have just trusted that the fund is right for you since you chose one designed for people with the year of your intended retirement in mind. However, not all target-date funds are designed the same way.
For example, the Fidelity Freedom 2035 Fund, designed for someone who plans to retire in or around the year 2035, has an asset allocation that’s 95% stocks and 5% bonds. By contrast, the Vanguard Target Retirement 2035 Fund has an asset allocation that’s 80% stocks and 20% bonds. Both funds have the same time frame in mind, but they are designed very differently.
It would be wise to determine your optimal asset allocation and then see how your target-date fund of choice lines up. SMI members can determine their optimal asset allocation via our proprietary process. Non-members may want to use Vanguard’s free questionnaire.
You may be better served by making your choice based on a review of the asset allocations of the funds available to you rather than the year that’s part of their name.
Allocating across multiple accounts and strategies
For SMI members, three of our strategies — Fund Upgrading, Just-the-Basics, and Sector Rotation — require that you know your optimal asset allocation since each one requires continuous exposure to the stock market. Our fourth strategy, Dynamic Asset Allocation, does not, since it will move you completely out of stocks if the strategy’s mechanical signals indicate it would be advantageous to do so.
As we’ve counseled before, if you have multiple accounts, it would be wise to treat them as parts of a single portfolio, making asset allocation decisions based on that big picture view rather than trying to optimize the asset allocation account by account.
If you are using multiple SMI strategies, including DAA, our standard recommendation is to apply your optimal asset allocation to the portion of your portfolio you are managing with Fund Upgrading and/or Sector Rotation. This is described in more detail in our article, Taking a One-Portfolio Approach to Your Investments.
Or, you could factor in the degree to which DAA lowers the risk of your overall portfolio, which may lead you to take a more aggressive asset allocation approach with the Fund Upgrading portion of your portfolio. This idea is expanded on in our article, Higher Returns With Less Risk: The Best Combinations of SMI’s Most Popular Strategies.
Ultimately, how you decide to apply the principles of asset allocation to your portfolio is up to you. Their application will likely vary from one SMI member to another. The important thing is that you are knowledgeable and proactive about making this decision.
How intentional have you been in designing your portfolio around your optimal asset allocation? How quickly and easily could you describe your portfolio’s design?