“Chicks, dig the long ball” – 1999 Nike Commercial
Turns out investors aren’t so different from baseball players – they want home runs.
One of the most dangerous misconceptions in investing is that achieving a home run with an investment is necessary to reach your financial goals.
Nothing could be further from the truth.
Turns out, your investment results are more complicated than just home runs.
Asset allocation, for all of its boring qualities, has more to do with your success than you were led to believe.
Asset allocation, or the mix of investments in your portfolio, refers to how your money is divided among different types of investments, such as stocks, bonds, and cash. This can also include commodities, alternatives (such as private credit, real estate, or private equity), and others.
By diversifying your investment portfolio in a way that makes you feel comfortable, you can balance risk with potential returns.
Your asset allocation can be one of the most important elements of your long-term financial success.
Don’t believe me?
The Brinson Hood, Beebower study of 1986 says otherwise. It estimates that roughly 90% of a portfolio’s return variance is driven by your asset allocation.
Of course, a multitude of factors also influence the performance of a portfolio, including the timing of your entry points, the investment vehicle itself (e.g., ETF, mutual fund, underlying stock), costs, market cycle, geographical exposures, investor behavior, rules and regulations, and many others.
Ultimately, making sensible investment decisions about your portfolio’s allocation necessitates at least a rudimentary understanding of the range of possible outcomes a portfolio may endure over time.
Take a look at the graphic below that shows various compositions of stock/bond portfolios, along with some important high-level risk and return attributes:
A few quick observations from that chart:
- Equities are typically the main driver of your portfolio growth. The one price you pay for that growth - volatility
- Bonds are generally recognized as the more stable asset class, but as the research shows, you give up almost 54% of your return for the privilege of “stability”.
- Cash is the most stable of all asset classes, but good luck with maintaining your purchasing power over time.
- Going all in with equity ownership, as shown by the portfolio on the right (100% stocks/0% bonds), has averaged a total return of 10.3% over the last 100 years, but at the expense of stability. In this portfolio, volatility will be part of your investing journey.
- On the other end of the spectrum, building a portfolio of 100% bonds, you can expect a narrower range of outcomes, which usually result in lower returns.
Understanding what’s in your portfolio, your risk tolerance, and when you’ll need your money (or your time horizon) are all key factors when it comes to making smart decisions about your asset allocation. You could be missing out on growth opportunities or introducing risk to your portfolio without knowing it.
Some helpful keys to helping you manage your asset allocation include:
1. Balance the potential risks and returns that come with different asset classes.
2. Revisit your asset allocation periodically to help your investment strategy stay aligned with your goals.
3. Rebalance your portfolio to keep it in check with your time horizon (or the amount of time your money will be invested before you need it), risk tolerance, and shifts in the market.
Ultimately, choosing the right mix of assets will be determined by your risk tolerance, time horizon, goals, and liquidity constraints. Adjustments will be made over time as life events occur and/or when circumstances change.
Rest assured that the equity markets are going to throw you a curve every now and then and offer reasons (some sound very legitimate) why you should deviate from your plan.
In the heat of that intense moment, always remember the successful investor's mantra: Stay the course.
Stay the course, my friends.