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The Asset Allocation Predicament: Part 1

Posted: May 11th, 2014 | Author: | Filed under: Uncategorized | No Comments »

The most important part of a portfolio is asset allocation. This refers to an investment strategy that aims to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according one’s risk tolerance and time horizon, among other factors. The three main asset classes are equities (such as stocks), fixed income (such as bonds), and cash. Each of these has different levels of risk and return and are expected to behave differently over time. How one determines to allocate his or her assets is always very personal as it will depend largely on your individual time horizon and your ability to tolerate risk.

One of the main reasons that asset allocation is so important is to reduce the risk inherent in volatile equity asset classes (stocks) that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets (such as bonds). In a nutshell, stocks are expected to perform better given enough time (often decades), but will have big ups and downs (volatility), while bonds are expected to have lower returns over the long run, but these returns are stable.

 

Real-Long_term-US-Stock-Growth

Market History: While there are always dips and spikes, there is a long-term growth trajectory. Image courtesy of VisualizingEconomics.com

You may be thinking that if ultimately stocks will have a higher expected return, why not just invest in 100% stocks. There are a number of reasons for this, however the two main ones are avoiding behavioral errors and ensuring a stable income stream in withdrawal years.  Having fixed-income assets in one’s portfolio will reduce volatility of one’s portfolio better enabling an investor to maintain a long term investment program (stay the course) without panic selling during bear markets (down markets). Everyone thinks they can weather a bear market, until they experience one and see large losses in their portfolio. Also, by having an allocation of a stable asset volatility is reduced which provides stability during your retirement/withdrawal years. You never know the length of a recovery after a down market, and if after a down market a recovery takes 10 years but you are planning on retiring in 5, you may be in trouble.

Figuring out how what the best mix of assets is something called “portfolio theory.” Now this may all sound complicated, but devising a successful portfolio turns out to be actually rather simple. In fact, if you were to compose your portfolio 2 funds, a Total World Market index fund and Total US Bond fund, you would beat 90% of professional money managers. All that would be left to do is ‘rebalance’ once a year or so.

Rebalancing involves buying and selling to return to your desired allocation percentages. This results in you taking advantage of the opportunities as the markets shift in and out of favor, inevitably buying low and selling high. For example, if your desired allocation percentage for stocks is 70%, but that portion of your portfolio has shrunk to 60% because the stock market is experiencing a downturn (low stock prices), you end up buying these stocks at low prices to bring back the allocation to 70%.

How do you figure out what percentage your allocations should be at? The old rule of thumb used to be that you should subtract your age from 100 and that’s the percentage of your portfolio that you should keep in stocks, the rest in a fixed income asset. For example, if you’re 30, you should keep 70% of your portfolio in stocks and 30% in bond. If you’re 70, you should keep 30% of your portfolio in stocks. However, with people living longer and longer, many financial planners are now recommending that the rule should be closer to 110 or 120 minus your age. That’s because if you need to make your money last longer, you’ll need the extra growth that stocks can provide.

While there may be specific tweaks and variations depending on one’s individual situation, as long as you stick to the basic principles of starting with a higher percentage of riskier/higher expected growth assets and moving towards more stable/lower volatility assets as they near retirement, you will do well.

Now that you’ve gone over this basic overview, it should be pretty clear that for the average investor, this a very straight forward and tried-and-true plan to financial stability (as long as they can stick to it). Unfortunately, for the Muslim investor, the obvious problem here is the High Haram Risk bond allocation. So what is one to do? We will begin to tackle that in the next part of this series.

 

Further reading:

The Oblivious Investor: Asset Allocation and Risk Tolerance

Bogleheads Wiki: Never bear too much or too little risk

William Bernstein on Asset Allocation

Bogleheads Wiki: Lazy Porfolios

The Coffeehouse Investor

 

Related Posts:

The Asset Allocation Predicament: Part 2



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