Today let's discuss why asset allocation, a basic but often misunderstood aspect of investing, is important. When you invest, you must have accumulated assets (like cash, but sometimes also stocks, options, real estate, cash-value insurance, precious objects, etc). Your goal should be to redeploy (allocate) these assets in ways to both maintain value and grow value ultimately providing the saver with financial security, peace of mind, and freedom.
Assets are any resources with value - value that can provide future benefits. There are many categories of assets and each category can have different characteristics. Managing this mix is critical because studies indicate that your decisions regarding the categories of assets you own have a major impact on the success or failure of your investment plan.
For example, the average individual owns a primary residence (sometimes their biggest investment asset). In addition, they may have a retirement portfolio, an investment portfolio, cash in the bank and perhaps other real estate investments. Within each of these categories are further subcategories. Investment portfolios can be divided into stocks, bonds, and mutual funds (and sometimes options). Further on, stocks can be domestic or international and can also be in larger, midsized and smaller companies. Or they can be in faster growing companies and slower growing companies, etc.
As you can see, there are many alternate ways to classify or categorize investments in the same portfolio. An important thing to remember is that sometimes these categories can be helpful, sometimes not.
An example of a fallacious category would be companies beginning with the letter 'S.' This category would likely not be helpful in managing a portfolio intelligently. It is important to think critically about these categories and classifications and also important to realize that sales-oriented firms may push new categories of little merit in the name of asset allocation. If it is a fallacious category, it might not really add much and could even detract from an investment portfolio.
There are several common traps and mistakes that investors make in regard to asset allocation of their wealth. First, a person may pay little or no attention to tracking the composition of their assets. Through lack of attention, they may continue to own risky or unattractive assets long after they should sell. A current example would be significant ownership of long-maturity bonds in a rising rate environment like today.
Second, beware of static or overly simplistic asset allocation systems. In many cases, firms push what I call mindless asset allocation whereby your age and income determine your suggested allocation. Using these models, firms typically suggest that the average 55 year old saving for retirement should have 60% in stocks and 40% in bonds. Shockingly, this advice may have been the same in 1983 and 2003. In 1983, bonds were incredibly attractive. Rates were high and bonds were unpopular. Bonds subsequently performed spectacularly for more than a decade as interest rates fell to multi-decade lows. In 2003, interest rates were already at multi-year lows and bonds offered little investment appeal.
The point is that asset allocation decisions should reflect changes in the risk and return associated with each type of asset. These changes are often inversely correlated to the price and popularity of the asset class. So in general, look to buy assets that are unpopular and cheap. This is a far better and safer approach than running with the herd. As they say, buy on the cannons and sell on the trumpets.
A third common mistake as mentioned above is to be misled by false categories. The popular growth versus value distinction, for example, is quite artificial and useless in many respects.
A fourth mistake is using asset allocation to justify diversification for its own sake. This is what Warren Buffett calls the "Noah's Arc Approach to investing" (Two of Everything). You would often be better off with fewer assets based on investment quality versus more for the sake of quantity.
A fifth very common mistake is to be overly concentrated, often based on emotions rather than logic. This last one is probably one of the deadliest mistakes people commonly make. Paraphrasing Mark Twain, they place all or too many eggs in an unsuitable basket and watch that basket not at all.
There are multiple examples of this fifth type of mistake. One is someone who may be scared of investing mainly because they are mortified of nominal losses. They hoard their cash and earn low rates of return. In the old days, these folks kept their money under the mattress. Though not deadly in a time of low inflation, being over-allocated to cash can be very risky over time. For example, cash can lose a lot of value and be very risky in inflationary times.
There is a better approach to asset allocation. The basic correct concept would be to pay careful attention to each asset or category of asset you own. Make a list and an initial assessment. Then continue to update your assessment of each asset. Each asset should be assessed from the perspective of how liquid the asset is (i.e. how easily it can be turned to cash), the future return the asset is likely to offer, the risk of loss associated with an asset, how well you or your advisor understand the asset and your confidence in its long-term prospects, and finally how correlated or uncorrelated the asset is with respect to your other assets.
You should also see to it that your overall portfolio has a sufficient level of diversification and margin of safety against the foreseeable bad events that could happen during your investment horizon without having so much diversification that you have compromised on investment quality.
Of course, this approach to investing and asset allocation requires thought and application. Unfortunately, there is no mindless rule that can substitute for intelligence, thought, or experience in investing. Make the proper effort or hire a good advisor who will do so on your behalf, however, and you can enjoy a lifetime of freedom and security.