When I was a little girl...
my mom used to give me one dollar to go to the candy store. That dollar taught me everything I needed to know about asset allocation, and I'll tell you exactly what I mean.
With one hundred pennies to my name, I had some major life decisions to make. While some children seemed to make brash decisions with their money, I was focused on getting the biggest bank for my buck. Back in those days when life was simple, I usually focused my finances on 3 things: Chips, juice, and a little Debbie cake. Even then, I came to the table with strategy because remember...
Candy store shopping included. LOL!!
Introduction to Asset Allocation:
Since each item on my list was 25 cents, that meant that I would be able to double up on one item, and this is how I learned the importance of strategically allocating your resources.
If it was hot outside, I knew that I needed to double up on juice. I was outside, the sun was hot, and I needed to protect myself against having to go inside for something to drink. If I went in the house my mom was liable to say, "come in, stay in!" in the way that only a #blackmom can. That would kill all the fun I had planned for the day and I could not have that. I had important things to do like skate, jump rope, or ride my bike. This was obviously before social media when kids actually did things outside. In person. With other kids. But I digress...
If I was hungry, I would go for an extra bag of chips. This is back when companies weren't so stingy and they actually filled the chip bag up to the top. Those were the days.
But by now you get the point... my allocation of one hundred pennies was based on my goals and needs at that particular point in time. Well guess what... financial asset allocation works the same way. Except instead of focusing on chips, juice, and cake, you are focusing on stocks, bonds, and cash.
Real World Applications:
As you determine how to allocate your portfolio between stocks, bonds, and cash, make sure that you are just as meticulous as I was in the candy store. You need to focus and consider your strategy.
According to the SEC's (U.S Securities and Exchange Commission) guide to asset allocation, there are two things to consider when developing your strategy:
1. What is your time horizon? (How long before you need to use your money?)
2. How much risk can you comfortably handle?
These questions should give you some insight into your risk tolerance, which should inform how you divide resources between stocks, bonds, and cash. Usually, the greater your risk tolerance, the more stocks your portfolio will have. If your risk tolerance is low, perhaps because you will be retiring soon, then your portfolio will include more bonds and cash so that it is not exposed to as much market volatility.
Ultimately, the reason we focus on asset allocation is because it accounts for over 90% of variations in portfolio performance (RBC Capital Markets). Also, since we know that different asset classes historically produce different returns, it makes sense to invest accordingly based on the above two considerations. This will minimize risk of being overexposed to any asset class, while also maximizing money making potential.
Asset Allocation Methods:
There are several methods you can consider when determining your overarching asset allocation approach. Here, I am only presenting 3:
1. Your age in bonds
This is perhaps the most traditional method, but it is very easy to understand and not a bad place to start. Ultimately, the idea is that the younger you are, the more aggressive your portfolio should be.
2. 110-your age in bonds
This is simply a slight modification of the first approach with a bit of added risk built in.
3. Core-Satellite Approach
This strategy, in some variation or other, is easily my favorite. The idea is that you build your core portfolio using ETFs and index funds. This keeps the majority of your portfolio safe in an investment that is intended to track the overall market or index. However, the satellite portion of the allocation is bit more risky to maximize the opportunity for financial reward.
Personally, I started with method 2 (using index funds and ETFs) and then transitioned to method 3 by adding more risky investments to the fringe of my portfolio.
As I Close...
No matter which method you choose, keep in mind that everything is not going to grow at the same rate over time, which means that your portfolio is going to need some occasional rebalancing. If you do this every 12-18 months, you should be good. Although, once you learn about more allocation approaches, keep in mind that some methods require more maintenance than others.
As for me, I am grateful for my days I spent in the candy store, obsessing over how to spend those 100 pennies. Who knew it would one day come in handy.