Asset Allocation for All Markets

Nora Dunn — Sun, 19 Oct 2008 11:09:02 +0000

Asset Allocation, being the distribution of your investment portfolio across different types of assets (known as “asset classes”), is not meant to be something that changes with the markets. In fact quite the opposite: a properly allocated portfolio is meant to weather both good markets and bad; to allow you to rest assured that your investments will reach your ultimate goals of what you need the money for without actively moving the money around.

The effects of proper asset allocation are not to be underestimated; the vast majority of your long-term returns are attributed to asset allocation – not market timing or selecting specific investments, as you might suspect.

But achieving the right asset allocation can be like groping around in the dark (and not in a fun kind of way!) if you don’t know where to begin. This article will help you to determine the proper asset allocation for your money. But first, some definitions of the different types of Asset Classes:

Cash

Despite its name, this allocation is not a license to hide money under your pillow! Cash investments include high-interest savings and money market accounts – ones that won’t make you a ton of money, but that are guaranteed and that will likely keep pace with inflation.

Fixed Income

These are mostly interest-bearing investments, and sometimes guaranteed (technically “cash” is a fixed income investment too). A fixed income investment won’t generally shoot the lights out in returns, but chances of investment losses are also capped. Examples are bonds, term deposits, and even some real estate derivatives.

Equities

Equities can be subdivided into Domestic and International categories. All equities are stock market investments, and of course not all stocks are created equal. This is where your financial planner (or a heck of a lot of research) will come in handy; differentiating the degrees of risk within an equity portfolio and reducing unnecessary risks. Although equities historically achieve the highest long term returns (by far) of any asset class, they will also see the most short-term fluctuation.

Large Cap (short for market capitalization) or Blue Chip equities refer to large, stable companies that have a good history, long track record, and fairly steady returns. Medium Cap encompass smaller or newer companies but still widely recognized ones, and Small Cap investments will often be higher risk investments: start-ups or smaller companies in less popular market sectors. The more risk you assume, the higher your potential return will be – within reason.

Domestic equities will generally be safer than International equities, because investing internationally subjects you to a new form of risk: currency risk. Your investment overseas may do gangbusters, but if your domestic dollar gains value comparatively in the meantime, you could actually see losses overall.

Sector

Sector investments refer to highly-specialized equities. They entail the highest amount of risk (along with potential for the highest gains), and should be limited in any portfolio. Examples of sectors include Natural Resources or Science & Technology.

Now to determine your own personal asset allocation and how to diversify your portfolio across the above asset classes. Here are a few questions to ask that affect your portfolio’s asset allocation:

What is Your Investment Time Frame?

The shorter your time frame, the safer your portfolio needs to be. The general rule is as follows:

0-3 years = short term
3-5 years = medium term
6+ years = long term

You will now recognize that the asset allocation for a portfolio used to accumulate and save money for a major purchase (short term) will look different from a retirement portfolio (long term). Even those who are on the brink of retiring need to consider how long this portfolio needs to produce an income (count on 20-30 years), so don’t set your date of retirement as the date you cash everything out; you may be cheating yourself out of some much needed returns to keep pace with inflation over the duration of your retirement.

Do You Need an Income?

For somebody retiring as above, you may have a long investment time frame, but also the need to draw an income from the portfolio. The more income you need (as a percentage of the entire portfolio), the more conservative a portfolio you should have.

The next question to ask under this category is “how long will you draw down on the investment?” If you expect to deplete the fund in four years (as with a child’s post-secondary education portfolio), then your asset allocation should be more conservative than somebody looking for 30 years of income.

What is your Marginal Tax Rate?

Depending on how much income you earn, you may be looking to shelter some of the growth from taxation, or even convert highly taxable income (like interest income) to tax-efficient forms of income (like capital gains). Your marginal tax rate may determine how to invest money you don’t have a specific direction for, and may influence the specific choice of investments within your portfolio.

Also if you expect your income to change in the next few years, your asset allocation could be affected. Sheltering gains during years of high income and producing taxable investment income during lower-income years are all specialized asset allocation strategies.

How Strong is Your Stomach?

This is probably one of the factors that will most influence your asset allocation choices, since you are the one who has to live with your investments. You may be young, saving for retirement, and showing all the technical signs of being a long-term aggressive investor, but if you can’t handle the heat when the markets do loops, it’s not worth the heartache. You will ultimately feel stressed out about money, will worry constantly, and will eventually bail – probably at the wrong time.

So how do these factors determine your investment mix? Here are six common types of investment personalities, and the recommended asset allocation for each.

Cash

You need the money within a very short period of time and cannot afford to lose a cent of it. You are likely accumulating for something like a down payment on a house, or some imminent purchases.

Allocation: 100% “cash”

Conservative

You have a short investment time frame, and a low tolerance for investment fluctuation. You may need to draw a hefty income from the portfolio now, or shortly. Hopefully you are not in a high income tax bracket, because a conservative portfolio will generate mostly taxable income (unless it is in a special tax-sheltered account).

Average Allocation: 15% Equities (all Domestic), 85% Fixed Income

Moderate Conservative

You either have a stronger stomach or a longer time frame than your conservative counterpart. You likely are still working within a short to medium time frame, but have the ability to expose a little more of your portfolio to fluctuation, with the hopes that you will achieve higher overall returns.

Average Allocation: 25% Equities (of which up to 10% can be International), 75% Fixed Income

Moderate

A true fence-sitter with a medium time frame, and/or a middle-of-the-road tolerance for risk, you are the picture of balance between fixed income and equities.

Average Allocation: 50% Equities (of which up to 25% can be International), 50% Fixed Income

Moderate Aggressive

You likely have a long time frame and a good ability to ignore market fluctuations to achieve your long-term goals of good returns. You are interested in sheltering income from taxation, and your moderate aggressive portfolio is likely geared towards retirement.

Average Allocation: 80% Equities (of which up to 40% can be International and up to 10% can be Sector), 20% Fixed Income

Aggressive

You are ready to hang it all out there, and in market scenarios (like the present) when news of the sky falling is rampant, you are cool as a cucumber. In fact, you are probably investing even more money right now (which is the perfect thing to do). You are interested in tax shelters, are young, and certainly have a long time frame to ride out the bumps.

Average Allocation: 100% Equities (of which up to 50% can be International and up to 15% can be Sector)

It doesn’t matter what stage of your life you are in: asset allocation applies to you! If you don’t have a portfolio to speak of and are looking at saving money each month, that doesn’t mean you don’t deserve to have a properly allocated portfolio: simply start now. There are lots of managed funds out there that will cater to your specific investment personality and will take care of the asset allocation for you within the fund. All you have to do is worry about saving the money; your solid asset allocation plan and the investment managers will take care of the rest.

This article is from Nora Dunn of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: