What is an Asset Class? What is Asset Allocation? How should you determine your Target Asset Allocation?
If you read my blog often enough, and have started to think I qualify everything I write about as ‘most important’ – then you are mistaken (and partly it is my fault). I might be saying those things in a different context.
For example, when I say compounding is your biggest friend, I mean it, but keep in mind that compounding happens over a period of time. When I say Asset Allocation is the most important factor in determining long term returns, I do not mean to say asset allocation is more important than compounding.
Things apart from Asset Allocation are important too, specially how much you save and how soon you start to save, how much expenses do you have etc; but once you have started to save/ invest, Asset Allocation is what will be a primary driver of your long-term returns.
What is Asset Allocation?
Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes.
If you do not understand big jargon like Asset Allocation and Asset Class (and some others) we are talking about today, please do not be discouraged, read till the end. I am introducing these terms so that you can interpret and understand host of information that is available on the internet on this topic.
I could have explained the basics even without using any jargon but I want you to be able to read that Wall Street Journal article with confidence the next time you see it, so getting familiar with the jargon is essential.
What is an Asset Class?
An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term.
By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.
While bonds on the other hand might return 10% in a given year or lose 10% in a given year. But over a long period of time, their returns are most likely to be lower than those of stocks.
Just to put things in perspective, stocks returned 10% over the last 28 years while bonds returned about 7% in the same period of time.
Simply stated - asset allocation is just the % of your portfolio you put in each asset class - a 50%/ 50% asset allocation means 50% in stocks and 50% in bonds.
A more aggressive asset allocation (higher in stocks as compared to bonds) is better suited for risk prone investors – say a 25 year old young chap who just started to work – no dependent, no large expenses, and a long working career ahead of him (generic ‘him’ that can refer to him or her).
While someone who is 55 year old and is contemplating retirement in 2-3 years might not be (and should not be) as comfortable with the riskiness (volatility) of stocks.
Various thumb rules exist – two most common are 100/110. So 110 minus your age should be in stocks. So if you are 30 years old, then 110 – 30 = 80% of the portfolio should be in stocks. For a 60 year old, only 50% should be.
Now let us briefly talk about expense ratio – expense ratio is the expense that you are paying annually to the fund/ ETF – this covers their management fee, admin fee, operating costs etc.
To put things in perspective – the lowest expense ratio I have in my portfolio is 0.02%, highest 0.48%, and overall average is 0.26% (overall average has ranged from 0.24% – 0.26% over the course of last 12 months).
Think of Asset Allocation as putting your hands into everything that is out there and expense ratio the cost that you incur in doing so.
A fundamental proposition that I believe in is – like you cannot time the market, similarly you can only expect to earn minimal (if at all) by trying to target specific asset classes when they are trading cheap. A good example – Oil fell a lot the last year or two, and many people are recommending buying oil on the pretext of ‘Buy low and sell high’.
Buy low and sell high is a great concept but almost impossible to implement unless you have a crystal ball that shows the future.
Assuming half of the Americans are invested in the stock market, we are talking about 150 Million Americans buying and selling stock. Is there something that all of them do not know/ understand but you do? If yes, then you should try to outperform the market, otherwise you should be happy if you track the market returns.
This recent published study shows that over the last 10 years, S&P 500 index has outperformed 82% of actively managed funds.
High Risk -> High Return
A picture says a thousand words. Here is a graphic that I created by collecting data for the last 25 years.
The overall theme: Risk and return are directly related. More the risk, more the probability of higher return. Converse is also exactly true – lower expectation of returns implies safer investments (lower risk).
The asset classes I considered in the above analysis include cash, alternatives, international bonds, US bonds, international stock, and US stock.
Here is the underlying data that went into creating the above graphic.
As you can see, average returns over long periods of time show a clear trend – they increase from top to bottom in this table.
At the same time, the ‘variance’ in returns (volatility/ risk) also increases from top to bottom. So stocks are more risk than bonds (that in turn are more risky than cash).
So far we covered – what is an asset class, some thumb rules to get started, and then risk/ return equation of each asset class.
Now it is time for us to revisit Asset Allocation. I earlier stated “Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes”.
To understand it conceptually, let us just take the two extreme Asset Classes – Cash and US stock. We know from our discussion above that Cash returns are the least BUT the cash returns are the least volatile. Cash does not have negative returns (leaving apart inflation).
US stock on the other hand has highest average returns over long periods BUT the volatility is also high – the returns are most variable.
Should someone who is two years away from retirement invest in stocks or cash? Keep Cash because the stocks might fall 50% in the next 2 years (they will recover at some point in time later but once you are in retirement you necessarily will need to sell your investments to finance your living expenses).
At the same time, someone who is 35 year old, single, stable job, no credit card debt, and a 6-month emergency fund invest in cash or stocks? Of course stocks, cash returns very little in nomimal terms (practically nothing if you take into account 2-4% inflation).
Should someone closer to retirement invest all of his money in cash and nothing in stock? Perhaps not… most of the money should be in cash (since cash and stock are the only two possibilities in our example) but some should be in stock. Why?
Because we want to be a part of the upside too – what if the stocks go up 50% in the coming 2 years?
Similarly, a younger person should choose to have something in cash but mostly in stocks.
This is all that there is to Asset Allocation. Things get computationally a little more interesting for 2 reasons:
- There are more asset classes, we just took an example of 2 asset classes to understand easily
- The risk tolerance of a person changes multiple times – for example with marital status, with job situation, with kids, and with age. So the Target Asset Allocation changes over a period of time – For me, today it is not what it was 10 years back and might not be the current one 10 years into the future!
The basic principles of Asset Allocation are applicable to any situation – the fundamental principle is balancing risk vs reward. Over long term, higher risk assets potentially provide higher returns but do you have a long term horizon?
It is important to note – just because you are young it does not mean that you have a long time horizon. People panic, in fact most people panic when stock market crashes – look at the stocks data I summarized for the last 25 years:
There were years when the stocks fell 40% – imagine you have been investing in the stock market and your portfolio has reached $500,000: You are excited when you start the year…. but as the year progresses, your portfolio starts to lose value….
Let us say – this is what your portfolio value through the first nine months looks like (Jan – Dec).
You started with $500,000 on 1/1 (Happy, you hit a milestone, kinda big deal).
By 1/20, the portfolio has lost $65,000, you are at $435,000; you lost 13% of the original value – possible over a period of 20 days.
You keep your clam and in fact buy more from the paycheck of 1/15 – after all, you want to buy low and sell high.
By 2/5, your portfolio has lost $34,000 further, in total you have lose $99,000 – close to a six figure loss. All the news channels say ‘This is the right time to buy on dips’ so you buy more from the paycheck of 2/1.
My mid of march, the original portfolio that was worth $500,000 has reduced to $388,000; you are worried, you ask Bobby and he asks you
- Do you have credit card debt?
- Do you have an emergency fund?
- Are you still at least 7 years more from retirement?
If you answered No to question 1, and Yes to questions 2 and 3; then he suggests that you invest your ‘every pay check dollar amount without worrying about ups and downs‘. Since you have faith in Bobby you listen to him and buy more.
By 4/25, your portfolio value is $370,000; now you are starting to get worried. Your spouse realizes that they will not be able to retire in the same city where you live now. Your children realize that you are not as likely to be able to help them with college tuition.
You have some cash at hand, that you saved from the pay check of 4/15 but you do not know what to do with it, you just keep it in your checking account.
Come 6/3, your portfolio value is $360,000; you have lost $140,000 in the last 6 months. The entire media (TV, newspaper, blogs, articles, magazines, barber shop, dentist, and restaurant waiting queues) is talking about how America is in recession and this might be worse than before.
You are dumb stuck, you never expected this to happen. After all, you expect your money to grow over a period of time. Savings from pay check of 6/1 stays in checking account. You are not buying but you are not selling.
Come 7/1, your portfolio is at $333,000 – this sounds like 2/3rd of what you started the year with. Everyone told you not to invest in stocks but you had the wisdom – you looked at data and took a calculated bet.
Here you are with $167,000 loss – this is 3 times your monthly salary. This is a third of what you have saved in your entire life.
Come 9/15, and your portfolio is worth $298,000. It is not even worth 2/3rd of what it was just 9 months back. America is going into recession. You are more worried about preserving your capital than chasing higher returns.
No end to this plight seems in sight and you SELL OFF!
If you can foresee yourself in this scenario, then do not fool yourself into believing that you have a high tolerance for risk.
Once you have started to save (hopefully early enough in life) and you have figured out the actual dollar amount you will save per pay check, your long term returns will primarily depend on Asset Allocation.
You need to spend time and think hard as to what is your risk tolerance and arrive at your Target Asset Allocation.