Asset allocation is an investment concept that refers to how much you have allocated to different asset classes.
Conceivably, there could be many asset classes that you track, including equities (the stock market), fixed income (bonds and cash), real estate, commodities, art, antique cars, bitcoin, jewelry, etc.
For the sake of simplicity, we’re limiting our discussion to equities and fixed income.
The asset allocation you choose is extremely important for the future performance of your investments. A classic 1986 study in the financial industry (by Brinson, Singer and Beebower) estimated that 91.5% of portfolio performance is based on the asset allocation decision, with 4.6% based on security selection, 1.8% on market timing, and 2.1% on other factors. A 2012 study by Daniel Wallick and his colleagues at Vanguard reviewed the 1986 study and concluded that asset allocation determined 88% of a diversified portfolio’s return.
So clearly, deciding what asset allocation you use is worthy of your time.
You may have heard of the rule of thumb that recommends you deduct your age from 100 to get the percentage of equities you should have. This would mean a 20-year-old investor should have 80% in equities, and a 60-year-old should have 40 percent in equities. I do not agree with this rule.
If we had a crystal ball – and could predict the performance of the stock market for the next 25 years – we could select our asset allocation without any risk. If we knew the stock market would be strong, we would choose a high percentage of equities. If we knew the stock market would be weak, we would choose a low percentage of equities. Many people try, but I do not know anyone who can predict the future accurately.
Someone recently predicted the stock market would not return anything for the next 10 years. He described it as a “lost decade,” which occurred in Japan between 1991 and 2001. In my view, that person has the same chance of being correct as assuming the stock market (S&P 500) will return 17% (including dividends) per year as it averaged for the past 10 years (2012-2021). If you are expecting future returns will be rosy, remember that the S&P 500 returned an average of only 1% per year in the decade from 2000 to 2009. Negative returns in 2000, 2001, 2002 and 2008 wiped out most of the gains for the entire decade.
So clearly, deciding what asset allocation you use is worthy of your time.
You may have heard of the rule of thumb that recommends you deduct your age from 100 to get the percentage of equities you should have. This would mean a 20-year-old investor should have 80% in equities, and a 60-year-old should have 40 percent in equities. I do not agree with this rule.
If we had a crystal ball – and could predict the performance of the stock market for the next 25 years – we could select our asset allocation without any risk. If we knew the stock market would be strong, we would choose a high percentage of equities. If we knew the stock market would be weak, we would choose a low percentage of equities. Many people try, but I do not know anyone who can predict the future accurately.
Someone recently predicted the stock market would not return anything for the next 10 years. He described it as a “lost decade,” which occurred in Japan between 1991 and 2001. In my view, that person has the same chance of being correct as assuming the stock market (S&P 500) will return 17% (including dividends) per year as it averaged for the past 10 years (2012-2021). If you are expecting future returns will be rosy, remember that the S&P 500 returned an average of only 1% per year in the decade from 2000 to 2009. Negative returns in 2000, 2001, 2002 and 2008 wiped out most of the gains for the entire decade.
Jason Zweig (of The Wall Street Journal) wrote a book titled Your Money and Your Brain. In his book, he tells a fascinating story about Harry M. Markowitz. Markowitz is well-known in the financial industry for his theories on risk and return and “Modern Portfolio Theory,” which he created and which led to a Nobel Prize in economics in 1990. Zweig tells the story:
In the 1950s, a young researcher at the RAND Corporation was pondering how much of his retirement fund to allocate to stocks and how much to bonds. An expert in linear programming, he knew that “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it or if it went way down and I was completely in it. My intention was to minimize my future regrets. So I split my contributions 50/50 between bonds and equities.
We would have expected an economist to use statistical analysis on his own portfolio to determine his asset allocation. However, Markowitz recognized that measuring risk and return was only a part of the solution. He knew that human behavior (and the way our brains lead us to respond to stock market fluctuations) cannot be predicted or controlled by theories and statistics. Markowitz understood how powerful emotional behavior can be. He was way ahead of his time.
The fact that Markowitz considered the uncertainty of his emotional behavior in managing his finances has become a fascinating field of research called behavioral finance.
If you have a financial adviser, discuss your asset allocation. Make certain that the asset allocation being used in your investment accounts is what you want it to be. If it seems too aggressive – or too conservative – ask your adviser to change it. If you do not have a financial adviser, I recommend you devote the necessary time to manage your asset allocation in your investment accounts.
Let’s assume you decide you want to use a 50/50 asset allocation. I recommend you review your investment accounts at least twice each year, because the allocation will likely shift to become heavier in stocks or bonds during the prior six months. In other words, if the stock market is strong, you may find that your asset allocation has shifted to 55% equities or higher. If the stock market declines, your asset allocation may shift to 45% equities or less. If the stock and bond markets have large swings, the shift in your asset allocation can become more drastic. Rebalancing your accounts is very important.
Limited space does not allow this article to thoroughly address the pros and cons of equities versus bonds. Some readers may be expecting that bond prices will decline (and yields will rise) during 2022 due to the Federal Reserve raising interest rates. This occurred during the first quarter of 2022 as U.S. bond prices declined roughly 6%. However, in my view, that does not justify using a higher percentage of equities in your asset allocation. Equities are typically far more volatile than bonds, as shown by the 33% decline in equities (the S&P 500) that occurred in March 2020 at the beginning of the coronavirus pandemic. Bonds typically play the role of a buffer, insulating investors from wild swings in equities.
We cannot control the short-term swings in the stock and bond markets, but you should always feel in control of your finances. Managing your asset allocation is a good place to start taking control.
This article was first published in the Albuquerque Journal.