What is Asset Allocation?
If you’re an investor, filling your portfolio with an appropriate mix of stocks, bonds, cash, real estate and other investments is critical to your financial health. This mix is commonly referred to as your “asset allocation.” It’s definitely not a “one-size-fits-all” proposition. You’ll need to set up your asset allocation to reflect your risk tolerance, financial goals, and timeline.
But how do you know know what to choose?
Nothing affects your long-term returns more than a good asset allocation plan. To see that I practice what I preach, check out my personal allocation strategy, Asset Allocation for Retirement.
Can You DIY Your Asset Allocation?
Before tackling asset allocation, it’s important to understand that your situation is slightly different than anyone else’s. So you must first decide on whether you want to DIY your own asset allocation, hire a professional advisor or use a robo advisor service to do it for you at an affordable price.
Doing It Yourself – Obviously, handling your own asset allocation allows you to save some money on paying professional fees and expenses. The downside is that you might not be updated enough on the goings-on of the stock market to choose the best diversification strategy for your personal needs.
Using a Robo Advisor – As a sort of middle-of-the-road option, a robo advisor (such as Betterment) will choose a preset allocation strategy for you, based on your risk profile. This allows you to feel confident in your decision without paying a ton of fees.
Hiring a Financial Advisor – A professional can help pin point the best allocation for your current situation and investment goals. However, they will be a bit pricier than if you tried tackling it yourself.
Betterment is the best robo advisor platform for beginning investors, with no minimum deposit and low fees... in-depth retirement tools and effective asset allocation... plus, it's possible to receive assistance from human advisors.
- Simple Asset Allocation
- Low Management Fees
- Perfect for Young Investors
- Tax-Coordinated Portfolio
- RetireGuide Calculator
- Flexible Portfolios
- Analyze Accounts Beyond Betterment
- Personalized Advice Packages
- Not for DIYers
- Cannot Asset-Allocate With External Accounts
- No REITs or Commodities
What Types of Assets Should You Choose?
The question is: What should you be investing in? A good place to start is with mutual funds and/or ETFs. These funds allow easy diversification without the possibly complicated process of stock picking. For most individuals, ETFs are usually the better choice. Though let’s discuss the differences between the two:
Mutual funds are collections of investments and can be either open-end or closed-end funds. Open-end funds are purchased directly from the fund manager. Their values are determined daily and there isn’t a limit on how many shares are issued. Close-end funds have a limited number of shares and the NAV does not determine the price.
When a mutual fund is sold, the fund has to sell shares to pay the investor. Usually, this will cause a capital gain that must be distributed to shareholders. This mutual fund turnover could result in higher taxes for you.
ETFs, or exchange-traded Funds, are made up of units of underlying investments. There are three main types: Exchange Traded Open End Index Mutual Funds, Exchange Traded Unit Investment Trusts and Exchange Traded Grantor Trusts.
- Exchange Traded Open End Index Mutual Fund: Connected to an index, dividends are reinvested when received, and paid to shareholders quarterly.
- Exchange Traded Unit Investment Trust: Required to fully replicate the designated index. Dividends aren’t reinvested automatically but they are still paid out quarterly.
- Exchange Traded Grantor Trust: Investor owns the underlying investments.
Unlike mutual funds, there is no need to sell when an investor wants to redeem their shares. Therefore, capital gains tax isn’t generally a problem due to fund turnover. ETFs also offer the possibility of arbitrage.
For more information about these funds, read Mutual Funds vs. ETFs.
If you are interested in branching outside the “stocks/bonds/mutual funds/ETF” routine, consider alternative investments. Different options you can explore include:
- P2P investing through Prosper or Lending Club
- Master Limited Partnership (MLP)
- Real Estate Investment Trusts (REITs)
- Ginnie Mae Bonds
- Commodities – Gold and Silver
Interested in one of these alternative investments? Read this article for more details about each! The rebel in you will be thrilled.
Diversify Your Portfolio
Every investment guru and their grandma will tell you that it’s incredibly important to diversify your portfolio. Why? By spreading your money over several asset classes, you are less likely to lose it all, should the market tank.
We all get the basic principles of “don’t put your eggs in one basket,” right? Great! Check out this article on doing the same thing with your business: “How to Manage Risk? Diversify!”
Unfortunately, when it comes to investing, diversification may not be as easy as you thought. Whether you are accidentally under-diversifying or even OVER-diversifying, diversification can be tricky! Here’s why:
What Can I Invest In?
Aggressive investors invest heavily in stocks. While they might have great diversification in stocks, their entire portfolios can take a nosedive when the market is down. Below is a complete list of the types of asset classes you can invest in.
Traditional Asset Classes
- Stocks — including value, dividend, growth and preferred, as well as small-, medium-, and large-cap, domestic, foreign, and emerging
- Bonds — including junk, investment-grade, government, corporate, short-term, intermediate and long term, as well as domestic, foreign, and emerging
- Cash — and cash equivalents
Alternative Asset Classes
- Commodities — including precious metals, agriculture and energy
- Real estate — including commercial, residential and REITs
- Collectibles — including art, coins, stamps, classic cars and vintage wine
- Foreign currency
- Insurance products — including life insurance and annuities
- Derivatives — including options, futures, and collateralized debt
- Venture capital
- Private equity
- Distressed securities
Here are some important factors to remember when creating your ideal asset allocation strategy:
Humans are emotional – It’s easy to invest when the market is good and really hard to invest when it’s not. When emotions come into play, you are likely to lean too far one way or another because it feels right.
Don’t be afraid of what you don’t know – By sticking to only stocks and bonds, you could miss out on some great investments. Educate yourself so you don’t miss out on these opportunities.
Investments aren’t scripted – Diversification will not protect your portfolio when all the asset classes tank at the same time as we saw during the financial crisis of 2007-08. That’s a big part of the game that people have problems with.
Avoid too many accounts – Managing multiple accounts can easily confuse you and cause you to forget to diversify one or more of them.
Be careful of diversification overkill – If you are diversifying your assets too much, you are likely missing out on potential gains and paying too much in transaction fees. The key is balance.
If I haven’t scared you too much yet, check out “6 Reasons Why Diversification Can Be Tricky” for more information on the subject.
One strategy to consider is tactical asset allocation or TAA. TAA involves active portfolio management by rebalancing the percentages of assets based on current economic conditions. For example; let’s say stocks take a plunge. You may want to temporarily rebalance your portfolio to focus on stocks. Why? Buy low, sell high. When everyone is scared, there are deals to be had.