Understanding how asset allocation can lead to a balanced portfolio

Asset allocation is the composition of different asset classes within a given portfolio. Traditionally, the four main asset classes to construct your allocation are stocks, bonds, cash and real estate. A good investor should have a solid grasp of what their asset allocation should be given their age, risk tolerance, financial goals and investment horizon. So, what is asset allocation all about and how can you use it to your advantage? Different investors have different habits and learning what yours are will help the most in your financial journey. Consider who you are as an investor and the best habits that will allow you to balance your portfolio.

Risk vs. Return

A tradeoff between risk and return constantly exists when constructing an investment portfolio. At the intersection of these two streets? Asset allocation.

Establishing a mixture of these four classes is akin to determining your speed while driving. Choose the leftmost lane (if you’re in the United States), driving as fast as you can, means subjecting yourself to more risks. But by doing so, your aim is to arrive at your destination at a sooner point in time. On the other hand, by driving at slower speeds you reduce the likelihood of negative incidents at the cost of quicker potential results.

To track and compare risk and reward among different asset allocation portfolios, use the Sharpe ratio. The Sharpe ratio is a financial metric that shows your average returns relative to the units of risk you experienced. Determining your optimal Sharpe ratio depends on various personal factors.

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Time Horizon

Young investors tend to gravitate towards a riskier investment mix as they can better sustain the chance of loss in their holdings. They have this ability due to their longer time horizons. An investor’s time horizon is the amount of time an investor believes they have to speculate with their holdings before requiring liquidity. The longer your time horizon, the more appropriate it is to increase risk in your overall portfolio since the market tends to produce positive gains over longer periods of time.

As your investment time horizon shrinks you should decrease the overall risk in your portfolio. If you have planned well and front-loaded your risk, then you will have a higher likelihood of achieving your financial goals.

This is the mindset of target date funds. These funds are frequently offered to participants of 401(k) programs. Target date funds select a point in time and reduce more volatile assets, such as stocks, in favor of safer assets, like bonds, as the projected date approaches. Although a hypothetically strong method, these types of funds have had their own issues which we will not discuss here.

Risk Tolerance

How much of your account are you willing to lose before you find no other conclusion but to sell all of your deteriorating positions. That point is your risk tolerance. More formally speaking it is the volatility an investor is willing to withstand in an attempt to obtain greater returns.

If you subscribe to our investment models then you know how your risk tolerance in our Stock Bond Rotation Model changes both your risks and your returns.

Exhibit A shows various metrics for the time period of 1/1/2000 – 5/31/2019 had you been invested as our Aggressive SBRM stated, or if you had held a static 70/30 portfolio. Exhibit B shows the same but for our Conservative SBRM and a comparable 40/60 portfolio.

The results are night and day. Our Aggressive model produced far greater returns but was over 40% more volatile than our Conservative model. The higher Sharpe ratio in our Conservative model also shows higher compensation per unit of risk taken while invested.

The Bottom Line

The age-old teeter-totter of risk and return needs to be properly balanced throughout your investment career in order to achieve optimal success. There is no one fits all when it comes to asset allocation. This is a highly personal choice that is the fundamental trajectory for a successful investment experience. If you want help deciding a favorable mix of stocks and bonds there are investor questionnaires to learn more about your personal investing habits. As always, if you have further questions please feel free to contact us!