A Primer On Asset Allocation!
Asset allocation is the action of dividing your investment portfolio over different asset categories, such as stocks, bonds, and cash.
As an example, a portfolio that holds 60% stocks, 30% bonds and 10% cash has a grade of A+ in asset allocation. The reason is that stocks, bonds and cash each have different risk profiles, and a balance between the three classes means your portfolio is not overweight in any single class.
Your personal choice for allocation will depend on two factors:
- Time Horizon: This is the amount of time you have available for your portfolio to work for you, before you require the funds to support yourself (i.e. retirement!)
- Risk Tolerance: How well you can sleep at night when your portfolio loses value (because it will – the level of loss will depend on your asset allocation)
I cover risk tolerance in depth in Zero to Portfolio (Masterclass), but the essential idea behind asset allocation is not to have all your eggs in one basket.
Why? Because if you trip and fall – yeah, no more eggs.
How is this different from diversification?
A diversified portfolio should be diversified at two levels: between asset categories and within asset categories.
Take the following two examples:
Sally has a portfolio that includes 45% stocks, 45% bonds and 10% cash. This portfolio receives an A+ for asset allocation. However, if Sally’s portfolio holds a single stock and a single bond*, this portfolio receives an F for diversification.
Sally wants to earn an A+ in diversification—what should she do?
Yep, invest in high quality, diversified (there is that word again!) stock and bond ETFs.
Annie has a portfolio that holds three ETFs, diversified across 10,000 domestic and international equities she receives an A+ in diversification but an F in asset allocation. Why? Debbie is 100% exposed to stocks and could consider an allocation to bonds and cash to decrease her risk while maintaining her expected portfolio returns.**
To end where we started: A kick ass portfolio diversifies across a) individual asset classes (stocks, bonds and cash) and, b) within each asset class (easily accomplished with ETFs).
Watch for our Lesson #8, our last official lesson, RRSP or TFSA? in your inbox in a few days!
*Especially if the stock and the bond are the same company, say the common stock of The Awesome Lipstick Company and The Awesome Lipstick Company 8.9% Feb09/2020 bond.
**Studies have shown that over a 20 year period, balanced portfolios enjoyed the same rate of return as higher risk portfolios, without the volatility (ups and downs). Meaning? It is not necessary to take on a high level of risk to achieve significant portfolio growth over the long term. ..and it’s crazy less stress.
The Fine Print:
Investing Bootcamp is provided as an educational resource and should not be construed as individualized investment advice, nor as a recommendation to buy or sell specific securities. The investments and scenarios discussed in the course are examples only and may not be appropriate for your individual circumstances.
The investing strategies presented in Investing Bootcamp will result in losses during any period of decline in the broad stock and bond markets. All investments carry the risk of loss. It is the responsibility of individuals to do their own due diligence before investing in any index fund or ETF mentioned in this course.