Asset Allocation Analysis

What Is Asset Allocation (AA)

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon. The main asset classes are equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

Why Asset Allocation Is Important

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market's short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put her money in a more conservative allocation despite a long time horizon.

Age-Based Asset Allocation

In general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. Bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor's age from 100 to determine how much should be invested in stocks. For example, a 40-year old would be 60% invested in stocks. Variations of the rule recommend subtracting age from 110 or 120 given that the average life expectancy continues to grow. As individuals approach retirement age, portfolios should generally move to a more conservative asset allocation so as to help protect assets that have already been accumulated.

But there are better ways to accomplish the asset allocation analysis. An elderly person who may have already accomplished their retirement goals may be setting aside money for a generation or two in the future. Even though they be older these kinds of asset allocation decisions would not be based on the age of the owner of the assets, but the full life-cycle of the future beneficiary.

Asset Allocation vs. Security Selection

Asset allocation and security selection are key components of an investment strategy, but they require separate and distinct methodologies.

Asset allocation is a broad strategy that determines the mix of assets to hold in a portfolio for an optimal risk-return balance based on an investor's risk profile and investment objectives. Security selection is the process of identifying individual securities within a certain asset class that will make up the portfolio.

Key TakeAways

• Asset allocation determines the mix of assets held in a portfolio, while security selection is the process of identifying individual securities.

• Asset allocation aims to build a portfolio of non-correlating assets together based on risk and return, minimizing portfolio risk while maximizing returns.

• Security selection comes after the asset allocation has been set, whereas assets, such as index funds and ETFs, are used to hit allocation targets.

• The Efficient Market Hypothesis shows that asset allocation is more important than security selection when it comes to creating a successful investment strategy.

Asset Allocation

It is well established that different types of assets tend to behave differently in response to market conditions. For example, in market conditions when stocks perform well, bonds tend to perform poorly, or when large-cap stocks outperform the market, small-cap stocks may underperform.

In investment terms, these assets are not correlated. Asset allocation is the practice of mixing non-correlating assets together to find an optimal balance of risk and return based on an investor’s investment profile. Asset allocation seeks to minimize portfolio risk while maximizing returns for an efficient portfolio.

For an investor who seeks higher returns with the willingness to assume more risk, the asset allocation is weighted more toward equities than bonds. An 80/20 or 90/10 mix of equities to bonds would be considered an aggressive allocation. Within the equity portion of the portfolio, the asset allocation can be further divided among aggressive growth stocks, emerging markets, small-cap, mid-cap, and large-cap stocks. A more conservative investor might choose a 60/40 or 50/50 mix of equities to bonds, with a larger allocation toward large-cap stocks.

Security Selection

After the asset allocation strategy has been developed, securities must be selected to construct the portfolio and populate the allocation targets according to the strategy. Most investors typically choose from the universe of mutual funds, index funds, and exchange-traded funds by matching the funds' investment objectives to the various components of their asset allocation strategy.

For example, a conservative investor may look toward funds that seek capital preservation in addition to capital appreciation, while a more aggressive investor may consider funds that strictly seek capital appreciation.

Passive investors tend to focus on low-cost index funds that attempt to replicate the composition of a stock index. A conservative investor might consider index funds that follow the Standard & Poor’s 500 (S&P 500) index or an index of dividend-paying stocks, while a moderate investor might mix an S&P 500 index fund with a smaller allocation in a mid-cap or small-cap fund.

Active investors, who seek opportunities to outperform the indexes, can choose from among thousands of actively managed funds. Larger investors, with more than $1 million of assets, might choose to work with a money manager who selects individual stocks to construct a portfolio.

Special Considerations

Asset allocation assumes uncertainty about the future direction of asset prices and that, depending on the market and economic conditions at any given time, some assets will increase, and others will decrease in value. Asset allocation is more about managing risk and volatility than it is about managing performance. Selecting individual securities assumes knowledge about the future and that the investor has some information that provides information about the future direction of prices.