There are thousands of books written about personal finance. Yet, there are only about ten that continue to outsell the others year after year. Why is that? Well, in my opinion, personal finance is more personal than it is finance. The finance concepts are generally simple and haven’t changed much. But the personal side…that’s a different story! Everyone has a better idea of how to handle money better than the last guy. Asset Allocation is most likely covered in every single investing or personal finance book written. I want to explain the basics of this concept and tell you why this is a perfect example of how it is much more personal than it is finance.
Asset Allocation decides what percentage of your money is held in each type of investments. Here is a list of common investments: stocks, bonds, real estate, commodities, cash, collectibles, etc. Each one of these asset classes has a more specific class within them. Within stocks, you can invest in domestic, international, small companies, or large companies. The list is almost endless, so what should you focus on?
Your first step is to determine how much money you should be saving. If I earn 10% on my investments instead of 7% because of a great asset strategy, it won’t matter much if I am only saving $10 a month throughout my career. Next, and these need to be done simultaneously, determine your time horizon and your risk tolerance. I say these should be done simultaneously because you can’t only invest in money market accounts your entire life and expect to retire. No matter how risk-averse you are, you will need some money in stocks during your career. Let’s start there.
Now that you know how much you are setting aside each month, your time horizon, and your risk tolerance, it is time to start determining your investments. The most important asset allocation decision is between stocks and bonds. The general rule is to invest mostly in stocks while you are younger and increase your bond allocation as you age. Stocks have higher returns over the long run, but they can fluctuate in price more dramatically than bonds. An important note; if you decided to pick a total stock fund and total bond fund and invest in them throughout your life gradually increasing the bond fund, you would probably be more successful than most investors. It doesn’t have to be complicated.
Let’s make it more complicated for the fun of it. The next step would be to determine your mix of stocks and bonds. What percent do you want in US vs. International, Small vs. Large, Growth vs. Value, Long term vs. Short, etc. I won’t go into the detail for these, but each one behaves differently depending on the market. Finally, we need to decide if you would like other investments such as real estate or commodities. Do you want to own a rental property or a safe full of gold? These can be included in your allocation as well.
Why do we go through this process to figure all of it out? A few reasons. One, you need to be comfortable with your investments and understand why you invest the way you do. Two, these investments have good and bad years. If you diversify among different asset classes that increase and decrease at different times, you can increase your return and reduce your risk if done properly. Third, and most important, stick with the strategy that you decide.
STICK WITH YOUR ASSET STRATEGY!
This is the most important sentence. If you pick a strategy and then change it when you panic because the market falls, you will be selling your losses and buying other assets at their highs. Pick your asset allocation and rebalance once or twice a year. Decide ahead of time when you will start reducing your stock positions or adding to your bond allocation. Don’t let the market influence your decisions.
It doesn’t have to be a complicated formula, but it does have to fit your personal goals. There is no right or wrong answer when it comes to deciding an asset allocation. There is, however, poor behavior that can damage your goals if you don’t stick to your plan.
For more detailed information about this topic, I suggest reading All About Asset Allocation by Richard Ferri.
Mike Zeiter, CPA/PFS