As a financial advisor, I often forget that many financial terms and strategies are not common knowledge. I have found that most folks that I meet with have heard many financial terms over the years but do not understand what they mean, and oftentimes are afraid to ask. I have decided to start a Financial Planning 101 series of posts that will break down common financial planning terms and strategies for my readers. I hope that these posts will help you gain financial knowledge and can help you to remove the guesswork from your financial life.
Financial Planning 101: Asset Allocation
I started this series off with Asset Allocation for many reasons. Mainly, it’s important! We believe in asset allocation when building a sound portfolio for our clients. It is an important part of any investor’s financial vocabulary and has a profound impact on your returns as well as your exposure to portfolio fluctuation.
What is ASSET ALLOCATION?
In simple terms, asset allocation is how one’s investments are spread out across different asset classes. This should take into consideration your goals, risk tolerance, and investing time horizon. Your allocation can be as broad as equities (or stocks/stock mutual funds) vs bonds/cash (or fixed-income) or it can delve deeper and show a more detailed look at all the sub-asset classes you hold. You may hear someone say that they have a “70/30 portfolio.” This typically means that they hold 70% equities in their portfolio and 30% fixed-income.
Why is ASSET ALLOCATION important?
It is a good strategy to use to diversify your overall investment portfolio. You have probably heard the phrase, “Don’t put all of your eggs in one basket.” This is an important component of asset allocation. With this strategy, you spread your risk out over many different asset classes. Thus, if one asset class (like emerging market equities) has a rough year of performance, you have other asset classes that may be able to lessen the fluctuation caused by the poorly performing asset class. Diversifying well over time may lessen the volatility in your portfolio.
Asset allocation can also help you to identify an investment policy to stick to long term. We know that prior performance does not guarantee future results, but by using asset allocation, we can try to build a portfolio that we can use as a benchmark when tracking progress toward our financial goals. A University of Chicago Study published in 1995, and since confirmed, found that over 90% of a portfolio’s total return was attributable to its asset allocation. We hear more noise in the media about market timing (“It’s a great time to invest!” or “Get out! The sky is falling!”) or security selection (think Mad Money on CNBC), but the overwhelming importance should be placed on having a sound asset allocation and sticking to it long term.
Sticking with a sound asset allocation long term would require that you rebalance your portfolio. This means periodically selling from your portfolio’s winning asset classes and buying back into the poorer performing asset classes to get you back to your asset allocation goal (Buying low, selling high). This is most often done quarterly, semi-annually, or annually.
Asset allocation is an important part of anyone’s financial plan. Most folks that I meet with usually have no idea how their household assets are currently allocated. They also usually have many different accounts that are disjointed and not working together efficiently. Meeting with an advisor and having a sound asset allocation strategy is a great way to help you to remove the guesswork from your financial planning.