Overview – No Two Investment Portfolios Are Identical
If you were to analyze the portfolios of 1,000 investors, chances are you won’t find any portfolios that are exactly the same. Rather, it would be unusual if you did come across portfolios that were identical to one another.
Different investors all have different goals, strategies, and follow their own investment paradigms. As a result, this directly influences the types of asset classes they have in their portfolios, as well as how much each asset class contributes overall to the portfolio’s composition.
Some investors own lots of equities, some bonds, and very little cash. Others may own lots of real estate, have a modest amount of cash, but have very little equities. The different combinations are seemingly infinite.
How do investors decide which asset classes they want in their portfolio, and how much each class will contribute to their overall portfolio? These sorts of questions all pertain to a field in investing known as asset allocation.
What Is Asset Allocation?
Asset allocation is the art and science of how to craft the optimal investment portfolio by taking several factors into account. Despite the simple premise, this is a very in-depth field, so it’s no surprise that countless textbooks, academic papers, and other works have talked about and analyzed this topic before.
Asset allocation can become very complicated, very fast. Some investment professionals have careers centred entirely on crafting the perfect portfolio composition for their clients to try and achieve the highest returns possible, using high-level math and complex algorithms to help them achieve that.
There are dozens of variables that influence how a portfolio is crafted: level of investment risk, desired investment returns, degree of diversification, risk management capabilities, tax considerations – the list goes on.
Unless you have a very large, complex portfolio that’s worth hundreds of millions or even billions of dollars, chances are you don’t need to be this granular. It would be very surprising if a new and/or young investor needs to go to this level of detail to manage their portfolio.
Examples of Different Portfolio Compositions
Although there are an infinite number of ways to arrange an investment portfolio, we will quickly look at a few example portfolios in order to see asset allocation at work.
Remember, there are several factors that influence how a portfolio is arranged. Asset allocation is all about accounting for these factors in the best way possible. The following examples will give hypothetical scenarios and how a portfolio may be arranged within certain parameters.
(*Disclaimer: the following portfolio compositions are for demonstrative purposes only. They are by no means “optimal” setups that will surely work in the real world, and therefore should not be interpreted as valid asset allocation strategies.*)
Example A
In this example, the scenario is as follows: a young investor (mid-20s) wants to achieve strong investment returns, is planning to invest for at least a decade, and is comfortable taking on higher than average investment risk. However, their modest means limit the types of investment instruments they have access to.
They don’t have any dependents and don’t plan on making regular withdrawals from their portfolio any time soon. Therefore, liquidity isn’t a major concern.
With this in mind, this investor may decide to go with the following composition:
Example B
Now, let’s imagine we’re dealing with an investor in their late 20s/early 30s who’s not only experienced but has lots of capital at their disposal and can invest overseas.
Just like the young investor from example A, they have no dependents and don’t plan on making regular withdrawals.
This investor also wants strong investment returns, but they prefer to have a well-diversified portfolio, across different classes, in different countries. Therefore, their portfolio may look something like this:
Example C
Our final investor is also in the same age range as the one from example B, but the difference is that they have a young family, and as a result, they’re more risk-averse.
They want their investments to act as a second source of income, and if they need even more cash then the investments should be reasonably easy to liquidate.
To them, they don’t really care about having superb investment returns – as long as they regularly receive earnings from their portfolio in the form of dividends, interest payments, or other forms of disbursement.
If that’s the case, their portfolio may look something like this:
Why Asset Allocation Matters, Regardless of Portfolio Size
If asset allocation has the potential to become very granular, and if this level of detail only affects investors with large portfolios, then surely this means investors with more modest portfolios don’t need to worry about it, right? Not exactly.
While it’s true that large portfolios need to be more careful in how they’re constructed, asset allocation is something that pertains to all investors, regardless of how complex or modest their portfolios are.
Although there are a seemingly infinite number of variables that investors must consider when crafting their portfolios, there are, arguably, at least two variables that influence every portfolio: investment risk and desired investment returns.
We’ve looked at investment risk before as well as the importance of learning to manage it. By properly designing your portfolio, you can keep risk to a level you feel is acceptable.
Different asset classes such as stocks, bonds, real estate, precious metals, and so forth all have different levels of performance. However, they all have varying degrees of investment risk as well – stocks generally perform stronger than bonds, but if the stock market were to crash tomorrow or if all your stock holdings suddenly de-listed, all your capital would be wiped out.
Investors are always trying to find the “goldilocks zone” of achieving satisfactory investment returns while being able to handle the level of risk that comes with it. This “goldilocks zone” varies for every investor because not every investor owns the same assets, or at least isn’t comfortable working with certain asset classes.
Asset allocation, in its most basic form, is all about finding the optimal balance between investment risk and satisfactory returns based on the asset classes an investor is willing to hold in their portfolio.
This is something that pertains to all investors, whether they’re just starting out or have decades of experience. Because of this, no investor can say that asset allocation doesn’t affect them.
How Your Investment Goals Influence Your Portfolio’s Composition
Although asset allocation can become very complicated, at the end of the day, how you design your portfolio ultimately depends on what exactly you plan to achieve. Once again, it loops back to having clear investment goals in mind.
If you want to achieve the highest returns possible and are comfortable with the higher than average investment risk, then perhaps you’re totally fine having a portfolio comprised almost entirely of equities.
Maybe you don’t like the idea of having all your investments tied up in the stock market and prefer something more tangible. Therefore, you decide to park your money in assets such as gold and silver.
Or perhaps you aren’t interested at all in capital appreciation, and the whole reason you want to invest is to provide a supplementary source of cash for yourself. Therefore, you may instead opt to purchase REITs, high-dividend stocks, and short-term bonds. Assuming you have the capital, you could also buy an apartment complex and use the rent that tenants pay as your source of income.
In the famous book The 7 Habits of Highly Effective People by Stephen R. Covey, habit #2 is “Begin with the end in mind”. Everything starts with having some sort of goal to work towards – the decisions, plans, and strategies that follow all centre around that objective.
Asset allocation follows the same idea – you start with a clear investment goal in mind, and how you construct your portfolio is done in such a way that you feel will help you reach your goal in the best way possible.
So, before even thinking about how to best divvy up the types of assets you want to own, the first step is making sure you know exactly what you’re trying to work towards. It’s very difficult to know how to craft your portfolio if you don’t even know where you eventually want to end up.
Asset Allocation Changes as You Progress in Investing
As you advance along your investing journey, it’s almost certain that your life circumstances will change as you go along. As a result, your investment needs will change too. Not only that, but the business and investing world changes all the time – investments that make sense today may seem foolish tomorrow.
The world changes all the time, so it’s only natural that an investor’s portfolio undergoes changes as well. It’s common for investors to adjust their portfolio’s asset allocation as they go along based on the changes they encounter.
A classic, yet common, example of a major influence on an investor’s portfolio composition is their age. The type of portfolio an investor has when they’re 25 will look most likely look very different by the time they’re 65. A lot can happen in 40 years, so if anything, it would be surprising if an investor didn’t make some changes to their portfolio during that time.
It’s also possible that an investor’s asset allocation changes because of their improved knowledge and/or because they now have more capital to work with. Some investors dream of purchasing an apartment complex or house to rent out, but buying real estate is a lot easier said than done. However, there may come a time when an investor has the knowledge and money needed to succeed in real estate investing.
Very few things, if any, remain static in investing. Investors live in an ever-changing world, so it should come as no surprise that the types of assets they own may change over time as well.
Wrapping Up
Asset allocation is the art and science of how to craft the optimal investment portfolio by taking several factors into account. There are countless asset classes in existence, so there are a seemingly infinite number of ways to arrange a portfolio.
Although it can become very granular and reach astonishing levels of complexity, asset allocation is simply the act of finding the optimal balance between investment risk and satisfactory returns.
Before worrying about how to arrange their portfolio, an investor first needs to have clear investment goals in mind. Without knowing where they want to end up one day, they’ll have a very hard time figuring out what exactly they need to do right now.
