Asset allocation is a term you’ve likely heard on the news when investments are being discussed. But what exactly is asset allocation and why all the fuss about it? In short, asset allocation is the process of trying to figure out how much of your money you want to invest in an asset class. The ultimate goal is to design an asset allocation that will meet both your risk comfort level as well as generating a return that will meet your investment objective.
If you’ve ever purchased a mutual fund from a financial institution, you’ve likely gone through the asset allocation process and nodded along when you had absolutely no clue (no worries, I did it too) what it meant. Here a short background on why asset allocation is an important thing when it comes to investment. Three guys named Gary Brison, Randolph Hood, and Gary Brinson who were bored (I assume) decided to research the effects of asset allocation. These wonderful lads found out that 93.6% of a portfolio’s variation in return was largely due to the strategic asset allocation of the portfolio. Wow! So basically 93.6% of an investor’s return is entirely based on how they design their asset allocation? Well..yes, and no. Most people interpreted the lad’s research paper on asset allocation as return variation rather than risk variation among portfolios. They weren’t really looking at returns associated with asset allocation.
Asset allocation is an extremely important thing when it comes to the expected return and risk of your investment. Therefore, it’s important you understand the underlining reason as to why you’re in a balanced fund, growth fund, or any other fund. Failing to understand the reason behind your decision to invest 70% of your money in equities and 20% in fix income, for example, will likely result in you not staying the course when things get tough. If you don’t understand why you’re doing something you likely will not stay the course over the long term.
There are two things you have to do when it comes to asset allocation; determine your strategic asset allocation and set up a rebalancing date.
Set your strategic asset allocation
I will use my portfolio as an example and please do not take this asset mix as a recommendation. I currently have a 75/25 split for my long-term strategic asset allocation. That means I have 75 percent of my money invested in equities (25% international, 25% Canadian, 25% US) and 25% of it invested in fixed income. Based on what I reviewed, I determined this was the right mix that would allow me to meet both my long-term return objective and risk comfort level.
What does the 75/25 split mean for me? For me, it means I will maintain my 75/25 ratio until I reach retirement or when I anticipate I will need the bulk of the money. This is what is known as your strategic asset allocation. The key part is the word strategic, which means it’s long term looking, unlike tactical asset allocation which allows you to move away from that strategic asset allocation to pursue short-term market opportunities. My only advice is to be aware not to become a speculator when employing a tactical shift within your portfolio.
Rebalance at least once a year
I will continue to use my asset mix as an example. Canada’s stock market is poorly diversified when compared to other stock markets. Our stock market is largely made up of oil companies, bank, and a sprinkle of telecommunication companies. And if you’ve been following the market you know oil prices went down and Alberta has been hit the hardest. Rebalancing is the process of ensuring your strategic asset allocation is maintained. In order to do this at times, you might have to sell certain asset class that has gone up in value while buying more of those asset class that has dropped in value. This is an important thing to do because markets will go up and go down, which means your long-term strategic asset allocation will be out of line. For example, at one point in the year, my portfolio was sitting at 70% equity and 30% bonds due to market conditions occurring in Alberta, which impacted my Canadian holdings.
If I left my fund alone, my strategic asset allocation would stay at 70/30, which is not in line with my initial asset mix. Rebalancing is critical to maintaining your strategic asset allocation.
Your strategic asset allocation is your formula to meeting your return objective while also meeting your risk comfort level. While rebalancing is the process of ensuring that formula is kept in place over the long term.
Think long term when it comes to investing and remember to rebalance at least once a year to ensure your strategic asset allocation remains in line.