What You Should Know About Asset Allocation

Jose Hernandez
Head of Education

Asset allocation is where the rubber meets the road with your investing; it determines how much risk you are exposed to and be a significant determinant of your returns (positive or negative).

This article will dive deep into what asset allocation is, why it’s important, and what to consider as you invest. Whether you choose your own mix, discuss your options with an advisor, or plug your parameters into a robo-advisor, knowing where your assets lie is essential to a healthy investment strategy.

Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.

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What is Asset Allocation?

Simply put, the definition of “asset allocation” is how you position your portfolio among the different asset classes. In other words, how much of your portfolio is dedicated to each type of investment vehicle. From there, you can examine your asset allocation through different lenses, such as by sector or market capitalization.

The most common way of visualizing asset allocation is with a pie graph that depicts the respective percentages of your portfolio dedicated to equities, fixed income, and cash/cash alternatives (if applicable).

Your asset allocation can range from ultra-aggressive (primarily equities) to ultra-conservative (primarily bonds and cash). Generally speaking, it is wise to dedicate plenty of time to figure which asset allocation is suitable for you as an investor.

What are the Benefits of Asset Allocation?

The main premise behind asset allocation is the idea of spreading out your risk among different asset classes. In theory, if part of the market or a specific asset class is underperforming, your entire portfolio won’t feel as large of a hit. Asset allocation tends to go hand in hand with the idea of diversification (which also aims to reduce portfolio volatility).

While there may be a valid argument that spreading out your risk may limit returns, asset allocation becomes increasingly important as your investable net worth increases. Like the old saying goes: “It’s not about how much you make, but how much you keep.”

It’s not just about the downside protection, however. Keep in mind that you will still have exposure to different asset classes and parts of the market. If those areas outperform, you will participate in that growth as well.

While it won’t make your portfolio bulletproof against volatility, proper asset allocation provides investors with the ability to protect their principal from concentration risk (too much of one investment). At the same time, it also allows investors to participate in broader market growth. Both of these components are critical for long-term success.

What Is Strategic Asset Allocation?

Strategic Asset Allocation is the process of selecting a particular mix of asset classes with the intent to hold onto that allocation for a long time (10+ years).

Many passive investors who use indexing and other passive investment vehicles choose a strategic asset allocation strategy. Strategic asset allocation tends to go hand-in-hand with Modern Portfolio Theory (MPT). This ideology states that markets are generally efficient and that keeping a diversified approach without attempting to ‘time’ the market is a wise play.

What Is Tactical Asset Allocation?

By most standards, tactical asset allocation is the opposite of strategic asset allocation. This strategy is much more active in nature. Investors that follow this philosophy believe that the market tends to present opportunities through mispricing securities and other events that may lead to arbitrage.

Instead of having a long-term target allocation, managers that use tactical asset allocation have a much shorter time frame that they use to analyze the positioning of the assets within their portfolios. Investors that use this approach may not believe as much in the theory of market efficiency and Modern Portfolio Theory.

What Is Core-Satellite Asset Allocation?

Core-satellite in a sense can be considered a mix between tactical and strategic asset allocation. In most cases, the “core” portion of the allocation is dedicated to broad-based, diversified exposure to different asset classes. This is typically done through indexing or using ETFs.

The “satellite” portion is usually a more active component of the overall allocation. This is where active strategies, hedging, and exposure to alternatives may play a role.

Many financial advisors and portfolio managers implement this strategy when their clients or investors demand a little more than just a “plain-vanilla ETF portfolio”.

What Is Portfolio Rebalancing?

Rebalancing is a core component of nearly any investment strategy, primarily strategic asset allocation. In short, portfolio rebalancing is the act of making the trades necessary to bring your portfolio back into alignment with your intended investment mix.

With time, your investment allocation can “drift” with the market. Think of it like a boat drifting off at sea. This can happen if the stock market runs up or down, and the same goes for the bond market.

Rebalancing can potentially allow you to lock in gains in an asset class that is outperforming and use those gains to purchase assets of a different class that may be at a discount. A classic example of this is selling off bonds when they are rallying to buy stocks currently trading at depressed prices.

Rebalancing may not always provide you with immediate returns. In fact, it may seem unattractive when a particular asset class is providing you with healthy returns. However, almost all investment professionals agree that it is a crucial element of a long-term investment plan.

What Asset Allocation Is Right For Me?

This is a great opportunity to remind you that every single investor is unique.

Why? Because every single investor has different circumstances, goals, preferences and needs. There is no “one size fits all” asset allocation (although Ray Dalio’s ‘All Weather Portfolio’ is an interesting case study).

Whether you’re constructing your own allocation or you’re getting help from an advisor, there are a few things you want to keep in mind.

Risk Tolerance

Risk is one of the most important areas of investing that you can study. Every single investor has their own level of risk tolerance. There is no “right” or “wrong” answer here. Only you can truly know your level of comfort with risk. When deciding on an allocation, this may be a great place to start.

Personal and Financial Goals

Goals should always drive the conversation in your finances. That principle carries over to investing as well.

One of the primary functions of a financial advisor is to create a plan that puts their client in the best position to be successful in meeting their financial goals. The advisor may do this through modeling and analyses (like a Monte Carlo).

In either case, the “best” asset allocation is the one that puts the client in a position to meet their goals while taking on the least amount of risk possible.

Time Horizon

Time is another crucial element in the investing equation. As a general rule, the more time you have until you’ll be relying on your invested dollars, the more risk you can afford to take. This is why it makes sense to have an aggressive allocation when you’re young.

On the other hand, as you get older or closer to your goal, it makes sense to begin paring back the risk you expose yourself to.

Individual Preferences

In today’s world, thematic investing is much more prevalent than ever. As such, there are more and more options available to investors that are passionate about certain themes (like sustainability, religion, etc).

If you are working with an advisor, you can have a conversation with him or her to see what options are on the table that are in line with your ethical stance. If you’re creating your own investment allocation, the burden of the due diligence is on you.

Robo-Advisor or Human Advisor?

If you’re not comfortable with creating your own asset allocation, that is okay. There are plenty of options on the table. The advent of technology has brought robo-advisors the forefront of the investment management conversation. As such, investors now have to ask themselves: “Do I want to work with a human, or am I comfortable with a ‘robo-advisor’?”

Again, there is no right or wrong answer here. However, there are some important points to note.

The benefit of working with a human financial advisor is just that; you’re working with a human. You’ll be partnering up with someone that you can have personal conversations with regarding your finances and investing. Many people like the idea of having a single point of contact for their investing and planning needs. On the other hand, because you’re getting a more individualized level of service, your investment costs may be higher.

If you aren’t picky about having a single point of contact (or a human quarterbacking your investments), a robo-advisor may make sense. As mentioned, this alternative is usually cheaper than working with a full-service, traditional financial advisor. If you go the robo-advisor route, it’s wise that you are comfortable and familiar with the platform.

In either scenario, you should do your due diligence and understand the process and philosophy behind the investment selection, rebalancing, fees and anything else that is important to you.

A Final Word on Asset Allocation

Asset allocation is arguably the most important element of an investor’s investment planning. It dictates how much risk you are exposed to, and is the primary determinant of your returns.

As an educated investor, you should strive to always make sure your asset allocation is suitable and in line with your investment objectives, as well as personal circumstances and preferences. And, while there are many schools of thought when it comes to the subject, there is still no “one size fits all” solution when it comes to how you position your assets.

Technology has made it possible for anyone to become an investor today. Leverage the tools and knowledge that are at your disposal.

Additionally, balance and discipline in your investing go a long way. If you’re not comfortable with creating and tending to your own mix, there are plenty of options available in the marketplace depending on your style and needs.

And last, but not least, keep striving to invest responsibly and intelligently. Prudent asset allocation is half the battle.

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Jose Hernandez
Jose Rafael Hernandez is known as "@thejoserafaelhernandez" on Instagram. He and his family are immigrants to the United States from Venezuela. The unique challenges that he faced at a young age taught him the real value of money and its importance in life. Jose studied finance at Mercer University, where he also competed in Division 1 Baseball. After his athletic career, Jose began his professional career in the finance industry. He started his career as a wealth management advisor for one of the top Investment Advisory firms in the US, where he was responsible for just north of $20mm in AUM. Jose currently holds the Series 7 and 66 licenses. Jose decided to leave the firm so he could have the freedom to create his brand on social media, geared towards educating millennials in the areas of personal finance and investing. His mission is to leave a positive impact on others while building his own legacy and providing for his family.