Portfolio Planning Basics – Picking an Asset Allocation

By on Jul 15, 2013 | Investing | 2 comments

Portfolio Planning Basics – Picking an Asset Allocation

This week we continue our in-depth look at creating an investment portfolio with our Portfolio Planning Basics series. We have already covered how to set your investment goals and determine your risk tolerance. Today we will look at picking an asset allocation for your portfolio. It will likely have the single biggest impact on your portfolio performance, so this step is especially important.

What is Asset Allocation?

Asset allocation is a portfolio diversification strategy used to reduce investment risk while maximizing return. The purpose of asset allocation is to get the maximum return for a given amount of risk you are willing to take on.

Asset allocation involves spreading your investments among different asset classes. An asset class is a category of investments that share common characteristics, such as risk, return and regulations. Instead of putting all of your investment money into one asset class, the key is to spread it among several.

Different asset classes behave differently, and while some may be declining, others may be appreciating in value. By having a diversified portfolio, you will improve your overall return. You can learn more about why asset allocation is important in this article on the College Investor website.

Major Asset Classes

Before picking an appropriate asset allocation for your portfolio, you need to understand the characteristics of the major asset classes. Here is a brief summary of each:

  • Equities: include stocks, mutual funds and ETFs. Equities tend to deliver some of the highest returns, but are highly volatile and risky. They are great for growing your portfolio, but don’t typically generate a lot of income. Equities can be further divided by:
    • Size: large (large cap), medium (mid cap) and small (small cap) sized companies
    • Location: U.S. companies (domestic), companies in other developed countries (foreign) and companies in 3rd world countries (emerging)
    • Industry: self explanatory
    • Growth/Value: growth companies tend be bigger and more stable, but grow slower. Value companies tend to be smaller and less stable, but can deliver higher returns
  • Bonds: bonds do not grow in value, but generate consistent interest income. They are much less risky than equities, but have smaller returns. Bonds are ideal for reducing overall portfolio risk or providing income during retirement.
  • Cash: includes savings & money market accounts and CDs. These investments have very low risk, but very small returns. They should only be considered by the most risk-cautious investors or those who have reached retirement age.
  • Real Estate: includes rental properties or companies that own real estate (REITs). The real estate asset class has a similar risk/return profile as equities, but much of the return is realized through income (rental payments or dividends).
  • Commodities: basic goods and materials, such as oil, natural gas, gold, silver, corn and sugar. Commodities are highly volatile, but can sometimes deliver high returns. Their performance has historically been very different than other asset classes, making them a good candidate for diversification.
  • Alternatives: there are other, less-common asset classes that you may consider when picking your asset allocation. These include peer to peer loans (such as Prosper or Lending Club), art and collectibles.

Picking Your Asset Allocation

Your asset allocation will depend on your investment goals and risk tolerance. If you are younger and have more time until you need to withdraw money from your portfolio, it’s best to invest in more high-risk investments (equities, real estate, commodities) to maximize your returns. If you are older and don’t want to risk loosing your investment money right before you need it, stick with less-risky investments (bonds and cash).

The first step is to determine an appropriate proportion of high-risk to low-risk investments. Here are three examples of asset allocations for various retirement portfolios:

  • Investor in her 20s, 35+ years until retirement, high risk tolerance:
    • High-Risk (equities) – 90%
    • Low-Risk (bonds) – 10%
  • Investor in her 40s, 15 years until retirement, medium risk tolerance:
    • High-Risk (equities) – 60%
    • Low-Risk (bonds) – 40%
  • Investor in her 50s, less than 5 years until retirement, low risk tolerance:
    • High-Risk (equities) – 30%
    • Low-Risk (bonds) – 70%

Next, consider expanding your asset allocation with some additional asset classes to supplement your equity and bond holdings. Which asset classes you include and how specific is you asset allocation will depend on your preferences and your particular financial situation.

To give you some examples, let’s use the same three retirement portfolios and break them down a little further:

  • Picking an Asset Allocation - Aggressive Portfolio Example

    Aggressive Portfolio Example | Click to Enlarge

    Investor in her 20s, 35+ years until retirement, high risk tolerance:

    • Large Cap U.S. Stocks – 25%
    • Small Cap U.S. Stocks – 20%
    • Foreign Developed Stocks – 15%
    • Foreign Emerging Stocks – 10%
    • Diversified Real Estate – 15%
    • Diversified Commodities – 5%
    • Diversified Bonds – 10%

 

  • Picking an Asset Allocation - Moderate Portfolio Example

    Moderate Portfolio Example | Click to Enlarge

    Investor in her 40s, 15 years until retirement, medium risk tolerance:

    • Large Cap U.S. Stocks – 15%
    • Small Cap U.S. Stocks – 10%
    • Foreign Developed Stocks – 10%
    • Foreign Emerging Stocks – 5%
    • Diversified Real Estate – 15%
    • Diversified Commodities – 5%
    • Diversified Bonds – 40%

 

  • Picking an Asset Allocation - Conservative Portfolio Example

    Conservative Portfolio Example | Click to Enlarge

    Investor in her 50s, less than 5 years until retirement, low risk tolerance:

    • Large Cap U.S. Stocks – 15%
    • Small Cap U.S. Stocks – 5%
    • Foreign Developed Stocks – 5%
    • Foreign Emerging Stocks – 0%
    • Diversified Real Estate – 5%
    • Diversified Commodities – 0%
    • Diversified Bonds – 70%

Understand that these are just examples and may not be appropriate for your particular situation. Do your research and make sure you understand the differences between various asset classes before purchasing any investments.

Asset Allocation Calculators

If you are having a hard time picking an asset allocation on your own, try using a few online asset allocation calculators. Their results will be slightly different, but they can give you an idea for what you should aim for. Here are some to get you started:

If you don’t have a desire to do your own research and pick your own asset allocation, you may want to use an online portfolio manager service, such as Jemstep or Betterment for a more hands-off approach. You can also email me and I would be more than happy to help you pick an appropriate asset allocation for your portfolio.

The next installment of our Portfolio Planning Basics series explains how to pick specific investments for your portfolio. And if you missed any previous articles or want to look ahead, the entire series is as follows:

What principles or tools do you use to determine your asset allocation?

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2 Comments on “Portfolio Planning Basics – Picking an Asset Allocation”

  1. Derek | MoneyAhoy.com

    One other asset class you haven’t considered is fine art and antiques. Otherwise, a really awesome list!

    • Anton Ivanov

      I didn’t expand on it that much, but I did mention art and collectibles when talking about alternative asset classes. For the right type of an investor, fine art can work well to diversify an existing portfolio.

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