Asset Allocation 101

Asset Allocation 101

The last several weeks we discussed a stock selection technique using multiple factors to rank our large selection pool into a more ordered (and smaller) portfolio of attractive candidates. This week we start a series of posts discussing a potentially more powerful - and important - part of our investment process called asset allocation…

What Is Asset Allocation?

When confronted with the dessert table at a holiday dinner, we often have to make the choice of which piece of pie to put on our plate. We could go “all in” on our favorite (pumpkin pie anyone?). Or we could take a sliver of more than one - not knowing how that pecan pie turned out this year after the adventure on the last go around. Another consideration could be whose feelings might be hurt if we do not at least try their latest creation. From a financial standpoint, the parallels to pie varieties are the general categories into which we can invest our hard earned dollars. There are countless ways to divide up the pie (or, universe - in financial terms) of investable assets. The most general way is to decide how much to put into cash, bonds, and stocks.

Is Asset Allocation Important?

The short answer is yes. Asset allocation is important because it provides us with a disciplined way to make investment decisions. Without discipline, our emotions come into play and we are bound to overload our “plate” with whatever just came out of the “oven” - even if it may give us a stomach ache around midnight.

Timing The Market MAY Work

There is a school of thought (namely technical analysis) which professes that it is possible to accurately - and repeatedly - identify the turning points at the “top” of the market and the “bottom” of the market in order to predictably buy “low” and sell “high.” This a very alluring idea that seems too good to be true and is akin to the idea that any toddler who can catch a bouncing ball may be destined for a career in the NBA. It may be theoretically possible, but it is also literally a one in a million shot at success. The chart shown above highlights the perils of trying to time the market and missing out on a portion of the gains.

Time IN The Market Does Work

A more “foolproof” method to improve the odds of our investing success is to make a disciplined commitment to stay in the market for the long term. A few years ago (before COVID-19), I hosted a summer series of classes titled Investment Camp. One of my favorite students is a young man named Oliver. I asked Oliver how he might define the long term - half expecting him to say this Saturday. To my surprise, he responded with the timeframe of 50 years. Oliver later admitted that his father had already schooled him on the miracle of compound interest and the idea of patience as a virtue. The following chart shows how $1 invested in the Wilshire 5000 index back in 1971 grew to $222 today - through six recessionary periods.

Investing Early And Investing Often

One way to mitigate the challenges of remaining committed to the long term when adopting an investment strategy is to invest early and invest often. By that, I mean to either ask your parents to start contributing to your UTMA account or your Roth IRA as soon as you have any earned income. This documented income can come from your household chores, that lemonade stand, or shoveling neighborhood driveways. When setting up these types of accounts, it is best to either automate the contributions or have a written policy (taped to the refrigerator, perhaps?) designating where your hard earned money will be invested and the incremental progress.

How To Allocate Assets?

Similar to the idea expressed above where there are countless ways to divide up the universe of investable assets, there are also several theoretically sound methods with which to choose how much money to put in each of these asset classes. The rational investor wishes to get a higher return for a given level of risk or lower risk for a required level of return. The holy grail is (of course) higher returns and lower risk. The unfortunate thing about investing is that nobody knows what will happen in the future. Like meteorological forecasters, investment strategists have limited foresight over the next few months and a much better idea about what may happen over the next few decades. Next time we will dive a little deeper into the idea of diversification.

“Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett

Disclosure

Past performance is no guarantee of future results. Any investment involves some amount of risk and may not be suitable for all — or any — individuals. You should consult with your investment advisor before acting on this information.

References

https://fred.stlouisfed.org/series/WILL5000IND#

https://www.visualcapitalist.com/chart-timing-the-market/

https://www.brainyquote.com/quotes/warren_buffett_173495