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Understanding Asset Allocation

Asset allocation is ingrained in how we manage our clients’ investment portfolios. But what exactly does it mean?

An asset is anything beneficial you own or have coming to you. For our purposes, it’s anything of value in your investment portfolio. After bundling your investable assets into asset classes, we allocate, or assign, each asset class a particular role in your portfolio. Generally speaking, the riskier the asset class, the higher the return you can expect to earn by investing in it over the long haul.

Allocating your portfolio into different asset classes is similar to storing your clothes according to their roles (pants, shirts, shoes, etc.) instead of just leaving them in a big pile in your closet. You may also further sort your wardrobe by style, so you can create ideal ensembles for your various purposes. Likewise, asset allocation helps us tailor your portfolio to best suit you – efficiently tilting your investments toward or away from various levels of market risks and expected returns. Your precise allocations are guided by your particular financial goals.

That’s it, really. If you stop reading here, you’ve already got the basics of asset allocation. Of course, there is a lot more we could cover. So let’s take a closer look at those asset classes.

Asset classes typically consist of the following broad categories, which can be broken down further into domestic assets, developed international market assets, and emerging market assets:

  • Equity/stocks (an ownership stake in a business)
  • Bonds/fixed income (a loan to a business or government)
  • Hard Assets (a stake in tangible objects such as commodities or real estate)
  • Cash or cash equivalents

Just as you can sort your wardrobe by style, each broad asset class (except for cash) can be further subdivided. For example:

  • Stocks can be grouped by company size (small-, mid-, or large-cap), business metrics (value or growth), and other factors.
  • Bonds can be classified by type (government, municipal or corporate), credit quality (high or low ratings), and term (short-, intermediate-, or long-term due dates).

We can then mix and match these factors into a rich, but manageable collection of asset classes – such as international small-cap stocks, intermediate government bonds, and so on.

To convert plans into action, we select fund managers with low-cost fund families that track our targeted asset classes as accurately as possible. Sometimes a fund tracks a popular index that tracks the asset class; other times, asset classes are tracked more directly. Either approach lets us turn a collection of risk/reward “building blocks” into a tightly constructed portfolio, with asset allocations optimized to reflect your investment plans.

 

Who decides which asset classes to use, based on which market factors? There is no consensus on one correct answer to this complex and ever-evolving equation. As evidence-based practitioners, we consider ongoing academic inquiry, professional collaboration, and our own analyses. Our goal is to identify allocations that best explain how to achieve different outcomes with different portfolios. We look for robust results that have been replicated across global markets; examined across multiple, peer-reviewed academic studies; lasted through various market conditions; and succeeded with real money in the real world, where trading costs and other frictions apply.

As we learn more, sometimes we can improve on past assumptions, even as the underlying tenets of asset allocation remain our dependable guide. By employing a sensible, evidence-based asset allocation to reflect your unique financial goals, including your timelines and risk tolerances, we help position you to achieve your goals over time.

Asset allocation offers a disciplined approach for staying on course toward your goals through volatile markets. This is more important than most people realize. As Dimensional Fund Advisor’s David Booth has observed, “Where people get killed is getting in and out of investments. They get halfway into something, lose confidence, and then try something else. It’s important to have a philosophy.”

So, now that you’re more familiar with asset allocation, we hope you’ll agree: Properly tailored, it’s a fitting strategy for rational investors seeking to optimize their long-term investment results. Please let us know if we can tell you more.