Asset Allocation
First, let’s try to distinguish between two interrelated concepts: asset allocation and security selection. Asset allocation involves the composition of a fund or portfolio by major asset class (equity, fixed income, real assets, cash, etc.) When we say that a portfolio is composed of 30% government bonds, 20% corporate bonds, 40% equity and so forth, we’re talking about asset allocation. Security selection happens at a deeper level. It involves the selection of specific investment vehicles within each asset class. The question as it relates to security selection is not how much should be invested in stocks, but specifically which stocks.
A portfolio that is 30% invested in large-caps, for instance, may behave very differently than one that is 30% invested in small-caps, but in terms of asset allocation, they’re considered to be equally invested in equities. That all may seem obvious, but it’s an important distinction to make because, in real life, most people are spending a lot of time and energy on security selection — thinking that a hot stock or an emerging ETF will make all the difference — when, in actuality, security selection has very little impact on long-term performance. Asset allocation, meanwhile, gets less attention but is much more important as a driver of results. Indeed, according to a well-known research study published in 1986, asset allocation was responsible for over 90% of portfolio returns.
One of the reasons that asset allocation is so important is because it’s central to macroeconomic risk management. Investing in different types of stocks may give investors a sense of security, given that each company may operate in a different industry with different prospects. But when a global or macroeconomic event takes the market by surprise — an unexpected rate hike, an economic contraction, a geopolitical crisis — the consequent shift in investor sentiment is likely to impact all equities, regardless of the industry in which they operate or their specific growth prospects.
A portfolio that is allocated for diversification, on the other hand, is designed to hedge against macroeconomic risk. Bond prices tend to rise when stock prices are falling. Private markets provide stability when public markets are volatile, etc. Simply put, investors should avoid putting all their eggs in the same basket. They should try to pay less attention to security selection and more attention to asset allocation. Doing so will not only protect capital from market swings, but it will also help investors capture opportunities in different market conditions. By allocating to less correlated asset classes, investors can effectively balance the risk and return of their portfolios.
Now, let’s delve a bit deeper. There are two types of asset allocation: strategic and dynamic. Strategic asset allocation pertains to the client’s long-term goals, which are based on the investor’s risk tolerance, investment time horizon, liquidity needs and return objectives. This type of allocation reflects the composition of assets required for the investor to achieve their goals without exceeding their tolerance for risk. Dynamic asset allocation, on the other hand, pertains to the kind of allocation that happens on the margins of the portfolio, where small tactical deviations may be executed in order to take advantage of market trends or economic conditions.
To determine how to execute asset allocation, one commonly used approach is the goal-based method— by identifying the client’s goals and risk tolerance, then building the asset allocation around it. Some investors are not willing to take short-term losses, even if they have the opportunity to achieve higher long-term gains, while others are willing to take a certain level of risk to achieve their goals but want to avoid large fluctuations. Remember also that not every goal carries with it the same tolerance for risk. Funds set aside for a child’s education, for instance, may require a more conservative approach, whereas funds set aside for vacationing may be more ambitiously invested. It all depends on the client’s priorities.
How do you determine the client’s risk tolerance? We can start by looking at the client’s investment horizon. Typically, the longer the investment horizon, the higher the risk tolerance. Longer investment horizons give the client more time to survive a significant market correction and avoid being pulled in by short-term fluctuations. For example, a young person entering the workforce is more likely to be able to tolerate higher risk because he or she is still far from retirement age. Thus, the client may exhibit a growth or aggressive growth risk profile and allocate more funds to equity and less to fixed income.
Conversely, the shorter the investment horizon, the less risk a client can generally tolerate. A client who is close to retirement, for instance, may not have enough time to wait for a market recovery before being forced to withdraw funds to pay for living requirements. As a result, this type of client may exhibit a balanced or balanced income risk profile and allocate more funds to fixed income and less to equity.
Risk tolerance is also dependent on the client’s own personality. At TD Wealth, we use a Wealth Personality Assessment as part of the Discovery Process in order to determine the client’s risk tolerance. Some clients are naturally reactive to market fluctuations, while others may not be. Risk tolerance is also related to different life plans and goals. These goals range from supporting lifestyle needs to ambitious aspirations. Does the client want to prepare for their children’s education expenses? Do they have a short-term plan to purchase a home? All these factors will affect their liquidity needs. Once goals have been determined, we can allocate funds to different asset classes according to the client’s risk tolerance and goals to build a complete investment portfolio.
Every investment has different risk and return characteristics, so asset allocation is never a simple task. Generally speaking, the higher the return potential for an asset class, the higher the potential risk. A portfolio that invests more heavily in cash and bonds tends to promote liquidity and stability, which may be appropriate for short-term lifestyle and education goals. A portfolio that invests more heavily in equity, meanwhile, tends to promote higher growth, which may be appropriate for funding long-term and more ambitious goals.
Great job on finishing our Asset Allocation lesson. Now it’s time to jump to lesson three on Diversification.
Frequently Asked Questions
Q: What is the difference between asset allocation and security selection?
A: Asset allocation determines the mix of assets held in a portfolio, while security selection is the process of identifying individual securities.
Q: Why is asset allocation so important?
A: Asset allocation reduces a portfolio’s risk exposure through diversification. Research has shown that, over the long term, asset allocation is responsible for over 90% of portfolio returns
Q: What is the difference between strategic and dynamic asset allocation?
A: Strategic asset allocation focuses on achieving the client’s long-term goals, while dynamic asset allocation refers to marginal deviations that can occur to take advantage of short-term market trends or economic conditions.
Q: How do you determine a risk appetite?
A: Risk tolerance is dependent on the your personality, your time horizon and need for liquidity. You may also exhibit different risk appetites in pursuit of different goals. Asset allocation aims to achieve your overall goals without exceeding your tolerance for risk.