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How To Use Investment Allocation In Investing

Lesson 6 - Asset Allocation: Slicing Up The Pie

Lesson 6 - Asset Allocation: Slicing Up The Pie

When it comes down to diversification, one of the first steps would be to decide what types of assets (stocks, bonds, REITs, etc) you want in your portfolio. This can be referred to as your asset allocation. If you refer to the Vanguard Portfolio Allocations Historical Averages page, you will get a taste for what I am speaking to. This is a comparison of the different percentages of stocks and bonds that could make up a strategy. Asset allocation can be much more complex but this is a great way to begin to understand the nuance.  

What is the ideal asset allocation?

Different allocations will have different average returns and also different amounts of volatility (the difference between the best years and the worst years). The portfolio with 100% fixed income (likely a total bond index fund) in it's worst year had a return of -8.13%, compared to it's best year of 32.62%, and only incurred a loss in 14 of the 94 years analyzed. The 100% stocks portfolio (likely a total stock market index fund) had a low of 43.13%, high of 54.2%, and lost value in 26 of 94 years. We would infer that the 100% stock portfolio had a higher amount of volatility. So we should just throw our money into a 100% stock portfolio because that is what has the best average return? 

This is the part where I tell you that these are the average returns for these portfolios over the course of 96 years. Unless we see some serious upgrades in medicine or we all get real serious about our diet/exercise routines, this is beyond our time horizons. No one can predict the future. If you have ever read the fine print for any investment, you know that past returns are not a guarantee for future returns. Investing is not an exact science. With that being said, this is the best data we have to work from so we can try to develop a strategy based on these data points. 

So what is the right allocation for you? There is no straightforward answer and in fact, even professionals in the finance industry have different opinions that can change by the year (mine have). A lot of it will depend on your risk capacity (this takes into account how long you have until you will need said investment) and your risk tolerance (how you will react if your investment takes a nosedive). A typical baseline strategy would say to possibly have a more aggressive strategy if you have a a high risk tolerance and capacity (example would be a young investor with plenty of time for retirement who can handle market swings), whereas ia conservative investor with a short time horizon might stick to a more conservative allocation. 

Asset allocation is a personal decision and everyone's is likely to be different. Be sure to take anything you read or hear from someone with a heavy dose of "is this the right decision for my personal situation?" Do plenty of research or reach out to a trustworthy advisor before making key decisions.