July 27, 2020Money Education Financial literacy
The Importance of Asset Allocation To Your Wealth
What is Asset Allocation?
Asset Allocation is probably the most important first step for the advisor and you to determine when constructing an investment portfolio. Asset allocation is the art of determining the ratio or allocation of the three main asset classes (cash, fixed income and equities) within a portfolio to meet your goals.
There are three main factors that influence your asset allocation; your risk tolerance, goals (objectives) and time horizon. Each of these are pieces in the large financial puzzle which help determine how much of your portfolio should be held in cash, fixed income and equities.
The idea is to hold assets with low correlation, meaning that different parts of the portfolio work at different times, the important thing is that the portfolio is working for you all the time.
Asset Allocation is Like Your Diet
The importance of choosing the right asset allocation is like choosing the right diet for you. We all have different eating habits and needs; we choose the right diet that we are comfortable with and is compatible to our overall lifestyle. Choosing the right combination of carbohydrates, veggies, fruits, dairy and meat in our diet is important for us to live a long and healthy life.
Picking the right diet and asset allocation totally depends on what you want to accomplish. Why do you eat? Why do you invest? Do you have a fitness or financial goal? A good doctor will tell you it’s important for everyone to have a food plan. The same applies with investing.
Understanding what you put in your body does to your overall health is the same as understanding what you put in your portfolio does to your overall wealth.
The first step is to assess your current situation and develop realistic goals. Stepping on the scale is a lot like having an annual review with your investment advisor. You assess your weight right now and document the steps needed to reach your goal.
Diets and asset allocation change over time just as our bodies and circumstances change. For instance, you are more likely to have more junk food in your diet when you are young. Eating junk food in your early years doesn’t hurt you as much as when you are older. This can also be applied to investing. Making mistakes in your portfolio hurts much less when you are younger because your portfolio has more time to recover, just like your body.
Your appetite for risk varies with age and circumstances as well, just like your diet. Teenagers are known to eat lots of fast food because their appetites have a high-risk tolerance. The risk of gaining weight doesn’t bother them as much as it would for someone in their 30s, 40s or 50s.
Some Healthy Habits
A certain diet or asset allocation is not the same for everyone, but there are a few general principles to follow:
- Do not concentrate your diet or wealth into one food group or asset class if you have a certain weight or financial goal. If your goal is to lose 5 pounds, what is the risk of eating a double cheeseburger? Your risk tolerance to eat that double cheeseburger in this circumstance is quite low, so your doctor would probably advise against it. The same applies for investing. If you depend on your portfolio to generate a certain amount of income, what is the risk of investing in a penny stock? Your advisor much like your doctor will probably suggest against it.
- Stick with your plan. Committing to your diet plan means that you are less likely to give into your cravings and eat that second piece of cake. The same applies to your investment plan. Having self discipline and keeping to your asset allocation will help you refrain from wanting to buy the next ‘big thing’, even if they are selling like hot cakes.
- Beware of fads! According to Eugene Fama (Nobel laureate and a founding contributor to Dimensional Fund Advisors), there is one robust new idea in finance with investment implications maybe every 10 -15 years, whereas the investment industry seems to create a new marketing idea every week, remember Bitcoin? Investors are encouraged to ignore fads and follow the sound principles of investing. Just like diet fads, most of the time you end up more overweight than when you started!
- Develop healthy eating and investing habits early. One thing we can probably all agree on is establishing good habits while we are young has added health and wealth benefits later in life. Those that have good habits are more likely to live longer and have a higher net worth than those who don’t. Talking with your investment advisor once a year is just as important as seeing your doctor for your annual check up. If you don’t do it, it might cost you.
Finding the right asset allocation is completely driven by you, your needs and your goals. There is no one portfolio fits all approach, just like there is no one meal fits all. And while you might enjoy the pizza and beer in the good times, much like during bull markets, it’s the consequences in the ‘bad times’ which determine the long-term health of investment returns.
Food for Thought
With that, I leave you with an idea from James Clear, the author of the New York Times bestselling book Atomic Habits. I was recommended this book by my coach in early January as I was asked to be a guest on a firm wide webinar on habits. I liked it so much that I suggested Gord read it as well.
"What is the real goal?
The real goal is not to “beat the market.” The goal is to build wealth.
The real goal is not to read more books. The goal is to understand what you read.
Don’t let a proxy become the target. Don’t optimize for the wrong outcome."
Hope you all have a wonderful summer and stay safe!