Part 3: The Asset Allocation Process
By Patrick Rau, CFA ∙ May 2016
In the first two articles in this series, I explained the basic asset classes, and the rationale behind combining their expected returns and risk characteristics to create the optimal portfolio mix. Now let’s apply these principles and replicate the thought process that many financial professionals use by creating a few hypothetical asset allocations. But before we dive into this process, we need to establish a few things.
First, What Are Your Specific Goals?
We all want to make as much money as we can, but that is pretty nebulous. What we are looking for are things like “I plan to retire by the time I am 65,” “my child starts college in 10 years, and it’s going to cost x per year,” or “I want to make a down payment on a house in 2 years.” Each specific goal will go a long way in determining just how aggressive or conservative your portfolio should be.
One thing you may want to consider is establishing separate portfolios with a specific target allocation for each. For example, if you are saving for college, that would be one separate portfolio, with its own target asset allocation. Your retirement account would be a completely different portfolio, with a different asset allocation. Maybe you have a third portfolio to manage funds you have set aside for a major purchase. If in rolling those sub-portfolios into one overall portfolio you find you are much more heavily weighted toward stocks than you’d like, then you can make adjustments accordingly. Of course, taking this approach might also show you that in order to meet your investment goals, you may have to assume more risk than you otherwise might have thought.
Next, Understand Your Ability & Willingness to Accept Risk
Your portfolio allocation is the product of the specific goals you set for yourself, adjusted for your ability and willingness to accept risk.
Your ability to accept investment risk depends largely on your time horizon, and your cash flow needs. The longer your time horizon, the more you can afford to accept risk, everything else being equal. If you earn well more than you need to pay your bills, have plenty of cash in the bank, are fully insured, and have no major expenditures on the horizon, then you have the ability to assume more risk as well. However, if you are living paycheck-to-paycheck, and/or have a few major payments coming due, then your ability to take on risk is lower.
Your willingness to accept risk is primarily a function of your individual personality. Are you more aggressive in nature, or do you tend to be more conservative? Many financial professionals like to have clients fill out a questionnaire to help pinpoint how aggressive they are (or aren’t), and there are plenty of free sites on the internet that can help you do the same.
But from a financial standpoint, I think the best question to consider is how much would a major market meltdown affect you? Would a 20%+ decline in the stock market cause you considerable angst, or would it get you excited about the possibility of loading up on a bunch of bargains? I hate clichés, but this one is pretty apt: your willingness to accept risk should be driven by whatever risk level helps you sleep at night.
Start With a General Allocation, Then Get More Specific
I firmly believe the most effective way to approach the asset allocation process is to begin with a more general portfolio allocation among the various main asset classes (stocks, bonds/fixed income, cash, and other), then break those down further into the different classes of securities within each of those main categories. For example, stocks can be classified by market capitalization and country focus; bonds by government vs. corporate, investment grade vs. junk, non-inflation protected vs. inflation protected; cash by bank deposits vs. money market funds; and other by real estate vs. commodities and other exotic investments. Sounds like a lot to wade through, and it is, but the concepts I lay out below will help you make sense of it all.
General Portfolio Allocation – The Main Asset Classes
Let me start with a brief description of the four main asset classes. You can turn to the first article in this series, Historical Asset Class Returns, to see how they have performed over time. In fact, you might want to print that out, and refer to it as you go along.
About the Author
Patrick Rau, CFA, is a former Wall Street equity research analyst on both the sell and buy sides. He has covered a number of industries over the years, including specializing in the oil & gas and semiconductor sectors, and serving as a generalist. For examples of his previous stock picks, please see the Equity Research tab. Pat is married to Brenda Rau, Licensed Real Estate Salesperson with Compass Real Estate in NYC.
Other Articles in this Series
Part 1 - Historical Asset Class Returns
Part 2 - Modern Portfolio Theory in Five Minutes
Part 4 - Mutual Funds vs. ETFs
Part 5 - Managed vs. Index Funds
Part 6 - Should I Hire An Investment Professional?
Part 7 - Things That May Improve Your Portfolio's Performance
Part 8 - Thoughts on Retirement Spending
Part 9 - Diagnostic Portfolio Checklist
Suggested Age Based Asset Allocations
These “suggestions” are actually a range of recommendations from ten different independent sources, including books, academic studies, and asset allocation calculators I found on the Internet. The idea is that conservative investors should veer toward the lower end of each range, while aggressive types toward the upper end. Note that the mid-points of the ranges for each age do not necessarily total 100%.
As you can see, the suggested ranges for bonds and cash tend to widen for the 55 and 70 year-olds, since these are the years when people are more likely to depend on fixed income to meet living expenses, and because time horizons for people later in life will be longer for some than for others.
Hypothetical Portfolios Based on Particular Investment Goals & Risk Profiles
These hypothetical portfolios are based on the “consensus” suggestions and financial principles I outlined in the previous section. Once again, I must reiterate that I am not a financial advisor, and these examples are not meant to be recommendations on my part. I am simply giving you examples of how financial professionals approach the asset allocation process, so that you can incorporate this type of thinking into your own decision making process.
Allow me to introduce you to five hypothetical investors. The first two are saving for retirement and are looking to build their overall net worth. The other three all have a major purchase forthcoming at some point within the next ten years.
The Internet Features Many Sites That Can Help You Create Target Allocations As Well
Some are free, some charge a fee. Let’s start with the free ones.
1.) FutureAdvisor.com - FutureAdvisor offers a free and easy to use online tool that will suggest portfolio allocations based on user age and general risk tolerance. Obviously, this is a one-size fits all application, meaning it does not take your specific goals and circumstances into account. But it is an excellent way to get started, whether you decide to manage your account yourself or pay a professional to do it for you. I also like that they give a detailed breakdown among 15 different sub-asset classes (domestic value stock, REITs, international bonds, TIPS, etc.) instead of just the 4 main asset classes (stocks, bonds, cash, other). FutureAdvisor can also manage your portfolio for you, for a fee, of course. This a great website to get started, or to compare against your existing target allocation.
2.) Morningstar.com - Morningstar has two free applications that I find to be extremely helpful. One is their portfolio planner, which calculates the statistical probability of growing your account to reach a specific financial goal, based on your time horizon, and your asset mix. The main drawback is these asset mixes are limited to five pre-canned allocations, ranging from conservative to aggressive, but they do give excellent insight as to how much more risk you may need to incur in order to achieve a particular goal. The other great tool is their Instant X-Ray, that will break down your portfolio allocation by asset class (stocks, bonds, cash, etc.), industries (basic materials, financial services, energy, etc.), stock type (slow growth, aggressive growth, etc.), region (North America, Latin America, Japan, emerging markets, etc.), and fees & expenses. For example, you may discover that your portfolio is far more heavily weighted toward banking or energy stocks than you are comfortable. You can then see what impact adding or removing other funds or stocks would have on your overall allocation. Instant X-Ray is an excellent diagnostic tool that every investor should run periodically, even if you hire someone else to manage your money. The free version of Instant X-Ray is likely sufficient to handle your basic needs, but Morningstar also offers a premium version that allows you to save your portfolio, and gives you access to other useful features.
3.) Brokerage Accounts – This is more of a “pseudo” free source, since you need to be a customer first. Chances are, your broker/dealer or the sponsor of your retirement account has an online feature that will suggest an appropriate asset allocation for you, and/or analyze your current investment mix. Fidelity.com is one such site. Your brokerage or retirement account sponsoring firm may also have specialists who can walk you through the process.
4.) Ask Your Bank – The bank that holds your checking account may also have a website and/or specialists who can help you, and quite possibly do so for free.
Prominent Pay Sites/Online Financial Advisors
I offer my thoughts on the pros and cons of hiring financial professionals in Part 6 of this series, and I highly recommend you read that section, particularly the section on just how fees can impact your returns over time. But for now, here are a few online financial advisors that may be able to help:
1.) WealthFront.com – Led by Burton Malkiel, author of the seminal book A Random Walk Down Wall Street. Wealthfront’s main advantage is they seek to minimize fees, and as I show in Part 6, fees can have a major negative impact on the future value of your portfolio. They only use low cost index funds, and automate much of their work. As a result, their advisory fee is just 0.25% of the assets under management, versus 1.0% or more for other firms. Wealthfront also has a very low minimum account size of $500.
2.) Betterment.com – Similar in style, approach, and fee structure to Wealthfront, but from what I can gather, you need a larger account balance to achieve the lowest fees.
3.) FinancialEngines.com – One of the oldest and most established on-line advisory sites. Co-founded in 1996 by William Sharpe, who received the Nobel Prize for Economics based on his work on the capital asset pricing model, and the very same gentleman for whom the Sharpe Ratio is discussed in Part 1 is named. Financial Engines charges an advisory fee based on the size of your portfolio.
One More Thing – Don’t Forget About Taxes
Note that the above hypothetical asset allocations, along with the majority of on-line asset allocation calculators and advice dispensed by financial professionals, are based on pre-tax data. However, the impact of taxes may cause your after-tax allocation to differ materially from your intended pre-tax allocation. Remember that your deferred tax accounts will be taxed at your marginal tax rate at the time you withdraw them, and your taxable accounts will be taxed at a combination of an ordinary income and a capital gains rate. However, your tax exempt accounts, such as a ROTH IRA, are exactly that. They are exempt from future taxes.
If you have most or all of your portfolio in taxable or tax deferred accounts, then your pre-tax and after-tax asset allocations will be similar. However, owning a significant amount of tax exempt securities, or otherwise taxable securities that you hold in a tax exempt account, can skew your after-tax allocation. For example, assume you want a 50-50 split between U.S. large-cap stocks and REITs. You own $100,000 of large-cap stocks in a traditional tax deferred IRA, and another $100,000 of REITs in a tax exempt ROTH IRA. If we assume a 28% marginal tax rate, the government in essence owns $100,000 x .28 = $28,000 of the stocks in your IRA, which means your after tax holdings are only worth $72,000. Your REITs are worth $100,000 after tax, because your ROTH IRA is tax exempt. That means your after-tax allocation is really $72,000/$172,000 = 42% for large-cap stocks, and 58% for REITs.
Next Time
We just covered a lot of material, and nice job navigating all this. Once you have established your target asset allocations, it becomes time to fill those in with actual securities. In my next two articles, I discuss the differences between mutual funds and exchange traded funds (ETFs), managed vs. index funds, and the criteria I use for selecting funds.
Patrick Rau, CFA, is a former equity research analyst, both on the sell-side specializing in energy and the buy-side as a generalist for a financial advisory firm. He holds a B.A. in Economics from the College of William & Mary, and an MBA in Finance from Georgetown University. He is married to Brenda Rau, Licensed Real Estate Salesperson with Compass Real Estate in New York City.
Disclaimer: All information and calculations are based on information deemed to be reliable. Patrick Rau, CFA is not an investment advisor, and this paper is for educational purposes only. Nothing herein should be considered financial or investment advice. Moreover, Patrick Rau, CFA shall not be held liable for any losses or damages that may result from any decisions you make based on any of this content.