How Are You Invested?
Asset Allocation Is Key to Making Sure Your Goals Are Met
Doug Wheat
With the S&P 500 stock index returning 31.9% in 2013, there is renewed interest by individual investors to invest in stocks. But with high returns also comes the risk of volatility. Asset allocation helps investors maximize returns while minimizing risks by utilizing diversification as a strategy for managing different market conditions. The appropriate asset allocation for you will depend on your goals, risk tolerance, and investment time horizon. With the run-up in stock prices, now is a good time to evaluate your existing asset allocation.
At its simplest, asset allocation can be seen as the mix of stocks (partial ownership of companies) and bonds (a loan to be repaid at a specific time and interest rate). Stocks help an investment account grow over time and have averaged a 9.6% annual rate of return from 1928 to 2013 as measured by the S&P 500. But, as we know, stocks are also volatile and may at times lose value. From October 2007 to March 2009, U.S. stocks lost 56.6% of their value.
Most investors would want to protect themselves against that potential volatility, especially if they are in or near retirement. Therefore, most investors would choose to diversify their investments with bonds which have historically provided less return (about 4.9% annual rate of return from 1928 to 2013), but with much less volatility.
Investors may add complexity to the asset-allocation decision by adding additional asset classes or by breaking asset classes into subsets. For example, many investors will have separate U.S. and international stock-asset classes and separate large- and small-company stock-asset classes. They may also have U.S. and international bonds. Finally, they may also have alternative-asset classes such as real estate, commodities, and private equity.
Adding complexity allows investors to add additional diversification to their portfolio, which may decrease the total risk of their investments.
For most people who are wisely trying not to time the market, widely quoted studies indicate that asset allocation is the most important decision investors make. A 1986 study by Gary Brinson is often misinterpreted, but the message is correct — investors need to pay attention to asset allocation. Indeed, Thomas Idzorek summed up the studies by Roger Ibbotson and Morningstar, stating in a 2010 article, titled “Asset Allocation Is King,” that, “in aggregate, 100% of the return levels come from asset allocation.”
There are an endless number of approaches to asset allocation. While there is much disagreement on the fine points, nearly everyone agrees that, for retirement goals, most investors will want to have aggressive allocations to stocks when they are young and become more conservative as they grow older. The reason for this is two-fold; first, younger investors have a long time horizon and can wait out the ups and downs of the stock market. Second, older investors have likely accumulated assets over their life, which psychologically they want to protect with more conservative investment strategies.
Investors have three basic choices when determining their asset allocation. The first is to keep things simple and choose a mix between stocks and bonds based on their age and risk tolerance. The second is to choose a single fund or strategy where an investment expert is deciding the asset allocation for a large group; target-date retirement funds are the best example of this strategy. The third choice is to develop an asset-allocation strategy that is specific to their circumstances either by working with an advisor or by doing a lot of studying.
The simple strategy is professed by John Bogle, the legendary founder of Vanguard. His advice is for everyone to have roughly their age in bonds. If you follow this strategy at 40 years of age, you would have 40% of your money in bonds and 60% in stocks; at 70 years of age, you would have 70% in bonds and 30% in stocks. As your age changes, so would your asset allocation. This strategy is conservative and may allocate more money to bonds than other approaches.
The target-date retirement-fund strategy is appealing because mutual-fund companies generally have sophisticated approaches to asset allocation and will include a combination of U.S. and international stocks, large and small stocks, real estate, and U.S. and international bonds. The asset allocation of these funds also change as you age and are designed to be a ‘set it and forget it’ choice, especially for 401(k) and 403(b) retirement plans. But if you choose this strategy, make sure you understand the asset allocation of the fund designated for your age and that you are comfortable with it.
Each mutual-fund company has a different approach to asset allocation for their target-date funds, especially as investors near retirement age. Most target-date funds are more aggressive than the simple John Bogle strategy. For example, let’s look at the differences of three 2020 retirement funds designed for investors between ages 56 and 60. The T. Rowe Price 2020 Retirement Fund has 68% in stocks, while Vanguard’s 2020 Retirement Fund has 62% in stocks, and the Wells Fargo Advantage Dow Jones 2020 Fund has 45% in stocks. The T. Rowe Price approach is more aggressive and may be expected to have both higher returns and higher volatility than either the Vanguard or Wells Fargo approach. This may or may not be comfortable or appropriate in your situation. If you just pick a target-date fund without checking out its asset allocation, you may be surprised at how aggressive (or conservative) it is.
An asset-allocation strategy that is specific to your circumstances will examine your goals, cash-flow needs, risk tolerance, and time horizon. The reality is that life gets complicated, and many times our needs cannot fit easily into a simple formula or box. In addition, if you have multiple investment accounts, you want to make sure all of the accounts are working in concert with each other.
Developing a personalized asset allocation will help you meet your own needs while making the most of the diversification opportunities available from investments in multiple asset classes. Depending on your own interest in researching the merits of different investment allocations and compiling information for all of your investment accounts, you may want to seek assistance from an investment professional.
There is no right answer to asset allocation, but make sure to carefully review your current allocation at least annually and make sure you have a strategy that is right for you. And don’t forget to keep saving.
Doug Wheat, CFP is the director of Family Wealth Management Inc.; www.fwmgt.com
