Asset Allocation Notes

Asset Allocation Notes What is an asset allocation? An asset allocation is the distribution of your wealth across different asset classes. Say that you have $50,000 to invest for retirement. If you invest $30,000 in stocks and $20,000 in bonds, you have allocated 60% to stocks and 40% to bonds. Your asset allocation is one way to describe your investment strategy. Why think about asset allocations? Asset allocation provides a very simple way to think about how you should invest. You only need to make two decisions: (1) what is my asset allocation, and (2) which securities go in to each asset group? As the course goes on, we’ll look at more complicated aspects of investing, but your asset allocation will still be the primary determinant of the risk and expected return of your portfolio. How do I pick the securities in each asset group? We could pick individual stocks and bonds, but for the moment, we want to take the simplest approach and invest in mutual funds. We want the mutual funds to be well diversified and low cost, so the best option is probably index funds. For example, in our 60/40 allocation, we would put 60% of our money into a stock index fund and 40% of our money into a bond index fund. Are stocks and bonds my only choices? Normally, stocks and bonds should make up the bulk of your portfolio. Some recommendations for asset allocation include other asset categories such as cash and real estate. Some recommendations split the categories up, for example, separating stocks into large‐cap and small‐cap stocks, separating bonds into corporate and government bonds, or separating international stocks and bonds from domestic assets. How do I determine the best asset allocation? Asset classes differ primarily by their average return and the amount of risk. Stocks typically have higher average returns than bonds but also more risk. There are also differences within asset classes: small‐cap stocks have more risk than large‐cap stocks; corporate bonds have more risk than Government bonds. The basic approach to asset allocation is to determine the appropriate level of risk for each investor. The greater the tolerance for risk, the larger the share of the portfolio allocated to stocks. There are a number of different factors that affect tolerance for risk. We will look at three major factors. Investing Horizon Some investors may be saving money for near‐term goals, such as a down payment on a house, or college tuition of a student in high school. Other investors are saving for goals that are far away, such as retirement. Typically, the farther in the future your investing goal is, the more risk you can afford to take. The logic is that if your investment performs poorly for a few years, you will have more time to make it up. For short‐term goals, you should primarily be investing in CD’s and low‐risk bonds. For middle‐term goals, you should have a balanced portfolio with a greater emphasis on lower‐ risk assets For long‐term goals, you should predominantly be invested in stocks. Capacity for Risk Other factors affect your ability to handle risk. For example, if you have a very steady income and a defined‐benefit pension plan that will provide you with a stable income on retirement, you can afford to take more risks with your own money. Tolerance for Risk Individuals also have different attitudes towards risk. Some people can live comfortably with the ups and downs of the stock market, while others will be constantly worrying about their money. People who are more uncomfortable with risk are usually advised to invest less of their money in stocks; however, it’s important not to get carried away with this. Stocks are still a good investment for long‐run goals. Also, a person’s attitude towards risk might simply reflect unfamiliarity with investing and so would change with education. Is there software to help me make these decisions? Software that recommends an asset allocation based on your personal financial situation is called an asset allocator. You can find a number of these online; some will be very sophisticated in terms of the number of asset classes and the kinds of personal information they use, while others just look at the basics. If you are using these to guide your investing, you should look at several and compare their recommendations. Is my optimal asset allocation fixed, or will it evolve over time? There are a couple of reasons your asset allocation might change over time. The first is, as you get older and closer to retirement, your investing horizon will necessarily get shorter. Typically, this means that you should be shifting your wealth away from stocks and towards bonds. However, people usually live long after they retire, and so you don’t want to eliminate stocks altogether. “Lifecycle funds” are a kind of mutual fund that does this for you. Instead of investing in separate stock and bond funds and then shifting the money over yourself, you invest in a mutual fund that invests in both stocks and bond and does the adjustment for you. Another problem is that bond prices or stock prices might change, changing your allocation. For example, say that you want a 70/30 stock/bond allocation. Stock prices have gone up more than expected giving you an 85/15 allocation. You may want to move some of your money from stocks to bonds to bring the allocation back to 70/30. This is called rebalancing. Alternatively, if you are still investing additional money, you can adjust the allocation by adding more of your money to the bond fund and less to stocks. Do I need to know more? This simple asset allocation process isn’t the be‐all and end‐all of investing, but it gives the beginning investor a good place to start and is still the foundation for the more‐advanced investor. As we go through the course, we’ll discuss some of the additional complexities.