Asset Allocation: The Great Balancing Act

Last week we explored the first part of asset allocation in Asset Allocation: Tools of the Trade. We reviewed the asset classes investment managers use to build portfolios for their clients. This week we will explore how client portfolios are constructed and change over time as assets are deployed. Before looking at the mechanics, we should review the primary foundational principle of asset allocation: client objectives.

Client Objectives

Every investor is different. While many may have similar goals, all have unique circumstances. Some might be looking forward to a retirement full of international travel and posh leisure activities. Other investors’ objectives may be more modest in nature, but no less important. Whatever the goal, good investment managers start by understanding their client’s objectives. Then, they put together an investment plan that will seek to meet these objectives while minimizing the risks associated.

Portfolio Construction

A big part of the investment plan is asset allocation, which is using different asset classes to construct a portfolio designed to meet client objectives. These asset classes are varied. They include cash, stocks, bonds, commodities, real estate, insurance, and more. Experienced investment managers use many or all of these asset classes in varying degrees to build portfolios for their clients.

Hypothetical Asset Allocation

To illustrate how asset allocation can work, we have a very simple, hypothetical case: Sam and Sally. Sam, 40 years old, is married to Sally, also 40, and they have no children.

They enjoy what they do, but both want to retire when they are 65. They plan to travel extensively and prefer to relocate to the beach upon retirement. That gives them roughly 25 years to make their world traveling, beach living retirement a reality. Both are comfortable with taking on higher-risk for the potential of more growth in their investments, so they are okay with greater volatility.

Understanding Sam and Sally’s objectives and risk tolerance is crucial for determining how to deploy assets in their portfolio, and typically there’s a lot to work that goes into determining the proper asset allocation. Let’s go forward with the understanding that this extensive planning process had been completed because the point is to illustrate the difference in asset allocation models at different stages in life. A reasonable asset allocation mix over time for Sam and Sally may be:

Phase 1: Age 40-55

• Allocate 60% in stocks, 15% in commodities/real estate, 20% in bonds, 5% in cash.
• Continue to work, receive average raises in relation to inflation, and save 15% of their income per year before taxes.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 2: Age 55-60

• Start re-allocating to a 50% stocks, 30% bonds, 10% commodity/real estate investments, and 10% cash portfolio.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 3: Age 65+

• Start re-allocating 30% in stocks, 50% in bonds, 10% in cash, and 10% in commodities/real estate investments.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

As this couple gets closer to generating income from their portfolio, their investment approach transforms from a growth portfolio to an income portfolio and you can see how their portfolio is restructured over time to reflect this. Still, at no time is their plan one of extremes. There is always a growth component and conservative component, just of differing degrees to reflect their needs in life.

Real retirement plans should never be all in one asset class, whether in growth mode or income mode. You need the proper balance to protect your plan from the multitude of risks out there. Additionally, you’ll notice this asset allocation schedule roughly follows the Three Phases of Retirement Investing. Asset allocation is fundamental to investment planning, and although there are different ways to be successful in managing your investments, it remains a staple of how to reduce risk.