The Art and Science of Asset Allocation
Many investors have heard the term “asset allocation” at one time or another. From the first time we sign up for a 401k plan at the office all the way through the conversations we have with financial planners in retirement we are bombarded with messages about the importance of proper asset allocation. But what is asset allocation, and what does it mean to investors saving for the future?
What exactly is asset allocation?
The easiest way to think of asset allocation is as the mix between different investment types. Stocks and bonds are the common example. A portfolio split into 50% stocks and 50% bonds can be described as asset allocated equally between stocks and bonds. An asset allocation in a portfolio of investments can be as simple as 100% of the same asset class or as complicated and exotic as you can imagine. In other words, some investors will end up with a portfolio concentrated in one or two types of assets (stocks, bonds, real estate, etc.) while others may want or need exposure to other asset types such as commodities, currencies, or alternatives like hedge funds and private equity.
How important is asset allocation for long term investors?
How important is it to get the asset allocation of an investment portfolio right? Opinions vary on the subject, with anecdotal wisdom being that asset allocation drives as much as 90% or more of return of a long-term, diversified portfolio. Other recent research from Morningstar suggests that portfolio returns are indeed heavily influenced by asset allocation but that other factors like security selection (stock or bond picking) make a significant impact as well.
Both folk wisdom and academic research agree on one important thing: asset allocation is a tremendously important decision for investors that impacts returns for years to come.
Where can investors get information to shape their asset allocation?
With asset allocation being so important it’s no surprise that the internet is full of calculators and commonly quoted rules of thumb that are all based on the “science” of modern portfolio theory. Simply put, they are all a good generic starting point, but none of these take into account important individual circumstances that should also influence an individual or family asset allocation strategy.
This is where the “art” aspect of asset allocation becomes so important. A surprising array of information can inform an asset allocation. Age, income, risk tolerance, and long-term goals are all basic building blocks that can point an investor in the right direction. Other important sources of information that can shape an asset allocation include such diverse things as industry (for those still working or drawing a pension), existing savings, future spending needs, liquidity events, family structure, and even insurance and annuity provisions.
As if this wasn’t already complex enough, many of these variables don’t stay constant and change on a regular basis, making asset allocation reviews and rebalancing an important discipline. Savvy investors will often seek the advice of an investment advisor, both for setting their initial allocation as well as to provide ongoing guidance and advice on how to achieve the optimal asset allocation for their individual needs. Given the importance of this art and science to long term returns, it’s no surprise that many of the best financial advisors out there start with getting the asset allocation right when building an investment strategy for their clients.
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Pilgrims Capital Advisors, Inc. is a Registered Investment Advisory Firm located in the state of Michigan.