Ask An Advisor: What is asset allocation & What should mine be?
When it comes to investing, having the right asset allocation is the most important thing that most investors need to worry about! Unfortunately, the financial press spends far more time covering titillating stories like corporate earnings, where the “experts” think the price of oil is going, or any other story that will add to their viewer or readership.
To understand asset allocation we must start with what the various asset classes are. Some people like to define this very simply as equities and fixed income. I prefer to take a more comprehensive approach which includes fixed income, REITs (real estate investment trusts), US equities, international equities, and commodities (gold, agriculture, energy, etc.).
Asset allocation refers to the percentage of each of the listed assets above that are in your portfolio. Since I cover them in my blog series I won’t go into detail here on the nuances of each of these asset classes; however, I can tell you that not everyone should have the same asset allocation. As a general rule, investors with a higher risk tolerance should have a lower percentage of fixed income relative to the other four I’ve listed. This is because out of the five asset classes, fixed income has the lowest expected volatility.
Conversely, clients that are more risk-averse should have more funds in fixed income as it can reduce the erratic movements of their portfolios, thus increasing clients’ peace of mind. Although fixed income unfortunately has the lowest expected return, it also has by far the lowest level of risk, defined as volatility. Fixed income also has the benefit of usually being counter-cyclical in its returns relative to the other four. For example, in the crash of 2008/09, international equities, US equities, commodities, and REITs all fell dramatically. Quality fixed income holdings, on the other hand, increased in value as investments fled the more volatile asset classes and flooded into “safe havens” like fixed income.
Interestingly, an area with increasing divergent opinions and controversy is what asset allocation seniors should have. Once upon a time it was advised that the percentage of fixed income in their portfolio should be the same as their age. For example, a 70-year-old investor would need 70% of his or her portfolio in fixed income. The thinking was that as people get older, they cannot withstand as much volatility in their portfolio.
Unfortunately, this may be a poor strategy for some seniors, given the increase in life expectancy. For example, a couple that are both 65 have a 72% chance that at least one of them will live to 85. This number rises to 81% for couples that are 25% healthier than the average.
As a result, a low volatility/low return portfolio could actually be riskier from a financial planning point of view because the lower return could cause them to outlive their money. In today’s low interest rate environment, blue chip fixed income securities are commonly yielding 2% to 4%. Given this, seniors with portfolios heavily weighted in fixed income would need a lot more money to start with; for some couples, this could mean running out of money before they die.
In the end, the only way to know what your asset allocation should be is to have a plan created for you that takes your current financial situation, risk tolerance, future income needs, and life expectancy into account. It’s a delicate balancing act, but a good planner can create a plan that fits your needs and monitor it along the way to ensure you can live the life that you’d like to!