So, what is asset allocation?
Asset allocation is a type of investing strategy and means that you spread your money between a combination of shares, interest and cash and cash equivalents. The general practice is that the younger you are, the higher the proportion of shares you own. This is because you have a longer investment period to compensate for losses if they occur.
The stock market always has trends up over time, so if you are young, time is also an asset. More experienced investors may have a higher proportion of interest holdings and are more dependent on regular income than on large equity gains.
Get the most out of your asset allocation
There are many reasons why you choose to invest. Some want to increase their wealth, others want to save for retirement, generate income or leave money behind for loved ones.
Unfortunately, there are investors and asset managers who do not understand some of the key determinants of long-term investment performance.
If you want to maximize the opportunity to achieve your long-term investment goals then I believe that one of the most important things to consider is the long-term asset distribution – the mix of shares, bonds, cash and other securities in the portfolio.
But this is something that investors and asset managers sometimes neglect, which can lead to substandard investment strategies for those investors.
When investors decide on a long-term asset allocation, they should be aware of some of the most common asset classes.
Here are three common asset classes that you should consider for your long-term asset allocation:
- Shares are an investment in a company in the form of owning a share in the company.
- Bonds – or fixed-income securities – are a type of loan to a company or a state against interest payments over time.
- Cash is simply cash, which is often invested in a short-term interest rate fund or some other interest-bearing alternative that can be converted into cash again at short notice.
This decision about the long-term asset allocation – ie how much of the portfolio is to be invested in shares, bonds, cash or other securities – is the most difficult decision for your investment strategy.
The 70-20-10 model
The 70-20-10 investment model can be a practical tool for developing a long-term investment strategy. This model is based on the idea that 70 percent of a portfolio’s long-term return comes from the long-term asset allocation.
Once you have arrived at a suitable asset distribution, you can start looking at different subcategories. According to the 70-20-10 model, about 20 percent of the portfolio’s return comes from the distribution between subcategories – the mix of regions, sectors, company size or other characteristics within each individual asset class – and the last 10 percent comes from the choice of specific securities.
The distribution between subcategories and the choice of specific securities are still important decisions.
After all, different securities in one and the same asset class can have different characteristics and returns.
However, the long-term asset allocation is crucial for your investment portfolio to give you the results you want.
The way through the funnel
In practice, the 70-20-10 model works as a funnel equipped with rigorous filters. Imagine pouring all the world’s securities – stocks, bonds, cash and more – through this funnel.
Only those who pass the filters inside the funnel reach the bucket below. Filtering begins with determining which asset classes are best suited to help you achieve your long-term goals.
Once you have found out which asset classes are best suited, you can focus on the next filter and determine which subcategories, countries and sectors are best suited to help you reach your goals.
This process makes the final screening – the choice of specific securities – much easier.
Instead of making fundamental analyzes of every single security in the world, you can sift through and limit the candidates to only those securities that fit the various criteria.
Asset distribution for individual investors
I am well aware that no two investors are alike. Therefore, it is essential that your long-term asset allocation is consistent with your personal financial goals.
To determine your optimal asset distribution, you probably need to take into account factors such as growth needs, cash flow needs, age, health and perhaps even your respective situation.
The time horizon for your investments – how long your investment portfolio needs to last – is also important.
You need to have your long-term financial goals clear to you in order to determine the time horizon for your investments.
For example, if you are planning to leave an inheritance, your time horizon should take into account the heirs’ life expectancy, health and other needs.
Investors often greatly underestimate the time horizon of their investments, as the average life expectancy is just an average.
And given the constant medical advances, the time horizon for your investment may be significantly longer than you think.
Your long-term asset allocation should take this into account.
What should you do and how should you invest?
So what’s the right mix for you? Do you need long-term growth, short-term cash flows or a combination of these? I believe that the decision is based on your unique financial situation, time horizon, risk tolerance and your expected expenses.
In order to find out which asset allocation is best suited to meet your growth and cash flow needs, it is, in my experience, good to think about how the planned portfolio would stand through several different scenarios, including extreme situations from history.
Investors can use historical market data as a guide when testing how their asset allocation – and ability to achieve their investment goals – would perform under widely differing market conditions.
In the event of major life events – marriages, divorces, births or deaths – it may make sense to update the distribution of assets.
But in everyday life, you should stick to the established asset distribution in the portfolio, because it helps you keep the course on the path to your financial goals, in my opinion.
High returns from niche investments can, for example, tempt one to chase momentum – that is, to invest in something just because it has gone well lately and received a lot of attention.
But I believe that one should stop and consider whether that investment would fit into one’s asset allocation first. If it does not, it may not be right for you.
Or maybe it’s been shaky on the stock market for a while. Knowing that your portfolio is designed to stand up to that type of volatility because you have weighed this into asset allocation can stop you from making hasty decisions at the wrong time and falling behind.
When the situation seems most difficult, a clear-sighted, well-thought-out plan can help you keep your nerves in check and stay the course. The future may be unclear, but a good distribution of assets gives you a map and compass to take your finances where you want to go.