Portfolio Allocation for Smarter Investing

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Portfolio allocation is an important part of determining the balance of risk and reward in your investments. Understanding how to invest and feeling comfortable with your decisions are often the most intimidating parts of building wealth.

The stock market can seem unpredictable, there are a thousand details to think about and remember, and there’s no shortage of anecdotal stories of massive loss and lucky wins from friends, family, and coworkers.

Investing doesn’t come as one size fits all. There’s no universal investing plan that will work for everyone.

Your best bet? Know what you want to get out of the market and work backwards from there. A good investor is an informed investor.

Part of being informed is understanding where your assets are held, diversifying your portfolio to minimize risk, and investing across asset classes and types. In other words, get familiar with portfolio allocation and what kind of arrangement of assets works best for you and your goals.

Basics of Portfolio Allocation

Portfolio allocation is an investment strategy that aims to balance risk and reward. Allocation aligns a portfolio’s assets according to your goals, risk tolerance, and time frame.

There are three main asset classes — stocks, bonds, and cash — and they all have different levels of risk and return. That means each one will behave differently, based on different factors, and perform in a particular way that’s unique from the other two types of assets you hold.

You can find additional subclasses of assets within these three main types. These include assets like small-cap stocks, corporate bonds, and money market funds.

Allocation is the specific mix of asset classes you hold in your portfolio. And your specific portfolio allocation won’t look exactly like someone else’s — because your goals, appetite for risk, and length of time you want to invest won’t look exactly like anyone else’s.

Portfolio allocation gives you a group of investments tailored to you.

The Importance of Diversification

Part of smart portfolio allocation is diversifying the assets you hold. It’s essential to creating a strong investment portfolio.

Diversification means spreading your investments across different asset classes, industries, and risk levels to ensure that your money is as protected from risk as possible.

For example, your portfolio shouldn’t be 100% technology stocks (or worse, 100% Apple stock and that’s it!) You probably don’t want to hold 85% bonds, either.

Both of those are too singularly focused on one area. If one of these asset classes suffers, your whole portfolio tanks with it.

A diversified portfolio contains stocks, bonds, money market funds (cash), ETFs and mutual funds invested in different industries, regions, sizes and styles. A more balanced portfolio might have holdings based on factors such as:

• Sectors or industries: technology, financials, energy, consumer goods and services, healthcare, real estate, and utilities;
• Geographic regions: domestic, international developed, emerging or frontier markets
• Size: large-cap, mid-cap or small-cap companies
• Style: growth or value stocks, corporate bonds or Treasuries, municipal bonds

How to Allocate Effectively

Allocating your portfolio will depend on your age, your comfort with risk, and your goals. A 60 year old and a 20 year old will have very different looking portfolios, because their needs and timelines are far apart.

In order to allocate your portfolio effectively, you need to know three important pieces of information:

• What you plan to do with the money that you invest
• When you plan to use that money
• How much risk you want to take with your investment

Let’s say you’re 40 years old and your portfolio is dedicated solely to retirement. The average age of retirement in the US as of 2016 is 63 years old. That means you have 23 years of investing ahead of you.

Traditional investing advice is to be more aggressive when you’re younger. Time is on your side when it comes to compound interest. Plus, you have a longer timeline to make up losses. The older you get, the less risky your portfolio should become.

A riskier portfolio means having more invested in stocks than in bonds or cash. Stocks have more potential for growth, but also run a higher risk of loss. Vanguard portfolio allocation models show the historical rate of return, as well as the number of years of losses, on different portfolio allocations.

As a 30 year old focused on retirement, your portfolio should be weighted towards stocks (or ETFs and mutual funds comprised of stocks). You have a long range timeline, so stocks give you the best chance of growth while you’re young.

In this situation, an aggressive investment portfolio would be 80% to 100% stocks. A moderate-risk portfolio would be made up of 45% to 79% stocks. And a conservative portfolio would be 20% to 44% stocks.

Again, this just illustrates one, very general situation. Most people’s goals and needs contain far more nuance — which is why a financial plan that encompasses not just retirement, but life between now and retirement, is so valuable. You also have to determine the appropriate mix of stocks to own: large cap, small cap, growth, value, domestic, foreign, emerging markets, sectors, etc. Small capitalization emerging markets stocks carry more inherent risk than large capitalization domestic “blue chip” stocks.

A prudent investment plan accounts for what portfolio allocation makes sense for you now, in a few decades, and far down the road into your later years. Your allocation can — and should! — change over time as your goals evolve and your life changes. You don’t want to simply “set it and forget it”.

Using ETFs Across Asset Classes and Types

ETFs, or Exchange Traded Funds, are a type of security that predominantly uses a passive strategy to follow (or track) another asset. A particular ETF may track a stock index, a sector, a commodity, or a bond index. ETFs share many similarities with mutual funds but also many more differences. ETFs are passively managed while mutual funds are actively managed. ETF prices fluctuate throughout the day as they’re bought and sold. In contrast, mutual fund prices change at the end of each trading day. ETFs typically offer better tax advantages compared to mutual funds because of how they’re structured and the effects on shareholders when shares are sold. With a mutual fund, taxable events occur for all shareholders when someone sells their shares. 

And ETFs are a popular choice for investment portfolios because they tend to cost less than mutual funds. You also have the ability to buy just one share.

Investors can also buy ETFs that are already diversified across different asset classes. ETFs allow investors to diversify in two major ways: across the three major asset classes (stocks, bonds and cash) and through investments that correlate to a major asset class.

A correlated asset would be an investment within one of the three asset classes, such as: Small-cap stocks, mid-cap stocks or large-cap stocks. Or Treasury bonds, corporate bonds or municipal bonds. Or T-bills or money markets.

ETFs can also be used to hedge your bets against a stock market drop. For example, if you have ETFs in one major asset class like stocks, you can hedge your losses by buying ETFs in bonds. There are even ETFs that short an index, industry or other benchmark to allow you to hedge your position in the event of a decline (but use caution – these are very complex instruments that may involve the use of derivatives).

ETFs are a simple, effective, and inexpensive way to add diversity to your portfolio and to help keep your allocation in balance.

By keeping your portfolio allocated towards diversity in asset classes, aligned with your goals, and in step with your age, you create a solid investment base for yourself. Portfolio allocation allows for smarter investing.


About the Author

Charlie Shipman left Wall Street and founded Blue Keel Financial Planning in 2014 to provide independent, fee-only investment management and comprehensive financial planning to professionals, business owners, entrepreneurs and their families. His goal is to help clients align their finances with the lives they want for themselves and their families. Areas of expertise include: cash flow planning and budgeting, business planning, financial planning, portfolio management, college funding, estate planning and risk management. Charlie has been featured in many respected online financial publications such as MSN, Yahoo! Finance, Nasdaq, Money, CBS News, The Motley Fool, and Investopedia. Charlie resides in Weston, CT with his wife and two young children, and serves as Treasurer for the Friends of Weston Public Library, Assistant Treasurer for Emmanuel Episcopal Church, and was a member of the Town of Weston Strategic Planning Committee.

For more information, or to reach Charlie, send an email to [email protected].

Author: Charlie
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