Investment Insights

What is Asset Allocation?

The best way to choose an asset allocation is tailored to your unique situation and maximizes the benefits of both volatility and compounding.

This edition of Investment Insights, the last in a three-part series, is about asset allocation. Contrary to volatility and compounding, the topics of the first and second entries in the series, respectively, the importance of asset allocation is more widely and far better understood. That said, I believe that what is known still falls short of its true impact on the practice of protecting and building wealth. 

This column then is an attempt to rectify this imbalance, by discussing what asset allocation is, why it is important and how it is determined. After doing so, the remainder of the column will try to integrate all three concepts – asset allocation, volatility and compounding – using a framework to protect and build wealth that I like to call “the stack.” If properly implemented and maintained, the stack minimizes the negative aspects, and maximizes the positive aspects, of volatility while at the same time creating the right foundation upon which uninterrupted compounding can occur. Before beginning, if you have not already done so, I highly recommend that you read the first and second entries in this series. 

The first two entries in this series each began with a dictionary definition of the subject in question. However, there is no dictionary definition for asset allocation. Rather, the best that can be done to capture the conventionally understood meaning of the term is to use the definition provided by the U.S. Securities and Exchange Commission (“SEC”), courtesy of their investor.gov website. 1

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This is a very good, mainstream definition of the term, correctly highlighting the three primary asset classes and capturing the gist of the exercise, deciding how to allocate your assets between the different classes based on your unique circumstances.

A more expansive definition, however, would include a longer list of asset classes, notably so-called alternative assets such as private equity, venture capital, real estate and hedge funds (to name just a few). Another nuance is how to treat further subdivisions, such as domestic and international equities or small and large capitalization equities. Unfortunately, there is no agreed-upon system of taxonomy such as there is for the natural world.

For the purposes of this discussion, we will limit our discussion to only equities, bonds and cash. This trio adequately captures the broad attributes of a wide range of potential asset classes and is more than sufficient to demonstrate the underlying asset allocation principles that will follow.

So why is asset allocation important? As it turns out, asset allocation is the single most important determinant of long-term investment returns. A seminal 1986 paper by Brinson, Hood and Beebower attributed 93.6% of the variance in portfolio returns to asset allocation choices. 2 So, the difference between a high rate of return and a low rate of return, or something in between, is almost certainly due to the choice of asset allocation.

Asset allocation, as the SEC definition above hints at, is also a risk management tool. Asset allocation manages risk via diversification. 3 Specifically, diversification reduces the risk from your investments being concentrated in one or a few assets or types of assets and reduces the risk created by volatility in investment returns (though reducing this latter risk may not be the best goal in isolation, as we will cover later).

Asset allocation is also important for imposing structure and discipline on your finances. 4 Merely having a goal and planning toward it, prerequisites for determining asset allocation, helps to narrow down your options and focus your efforts.

There are many ways to set an asset allocation, though there are a few common methods that people use. The simplest, a rule of thumb of sorts, is to set your equity allocation percentage to 100 minus your age. Using this method, a 20-year-old would have 80% of their investment assets allocated to equities while an 80-year-old would have only a 20% equity allocation.

Target date funds do something similar. A 2065 target date fund at Vanguard, appropriate for someone in their early 20s, is comprised of 92% equities and 8% bonds, while a 2035 target date fund, appropriate for someone in their early 50s, is comprised of 72% stocks and 28% bonds. Not quite the same as the rule of thumb, but directionally similar.

Another way to choose an asset allocation is to set tolerable risk and return parameters and select asset allocation percentages that most closely match those parameters. Someone who wanted a 6% expected return and a 10% standard deviation of returns might choose to allocate 50% of their assets to equities and 50% to bonds, while someone who wanted a 10% return and could tolerate a 20% standard deviation might allocate 100% of their portfolio to equities. One caveat with this method is that not all combinations are achievable and tradeoffs must be made. We would all like a portfolio with a high expected return and low volatility, but such a thing does not exist.

Asset allocation can also be set based on income needs. In this case, a portfolio needs to generate a fixed amount of income and the allocation between equities and bonds is set at an appropriate level to do so. Note that this method explicitly places a lower priority on growing the overall size of the portfolio over time.

The flipside of an income-driven approach to setting an asset allocation is a growth-centric approach based on reaching a chosen financial goal in the future. In this case, income generation would be deprioritized and the asset allocation would be set such that the portfolio appreciates to the desired future value. Depending on the required return, though, this method may require taking on more risk.

A final method of asset allocation is the portfolio management strategy created by David Swenson at Yale University and now widely used by institutional investors. Swenson used a wider breadth of asset classes, relying heavily on illiquid alternative assets, with an emphasis on diversification and maximizing risk-adjusted return along something known as the efficient frontier. 5

Having learned several traditional methods of asset allocation, it is time to introduce a method I call the stack. It is important to note though, that the stack may not be appropriate in all situations or for all people. The stack is premised on a guiding objective to protect and build wealth. 6 Where that is not the case, another method may be preferable. Where suitable though, the best way to describe the stack is as a stratified asset allocation based on liquidity needs.

The stack begins by taking a comprehensive look at your overall financial picture, not just your investment assets. This requires a deep understanding of your liquidity needs, which depends on your expenses relative to your income and on any upcoming non-recurring cash requirements.

Generally, the stack would look like this. The top layer would essentially be a working capital account, often a checking account, where cash comes in and out on a regular basis and instant liquidity is the only priority. The next layer down in the stack would be something like a savings account or money market fund, where money that is, or could be, needed in the near future is held. Here, there is the potential to earn a modest return on your money, but the guiding priority is preservation of capital. These first two layers of the stack are not typically considered investment assets.

Investment assets begin with the next layer down. This layer is comprised of short-term bonds where the return is higher than the previous layers but the principal amount is subject to modest fluctuation. The purpose of this layer is to satisfy longer-term liquidity needs. For example, if you were planning to buy a home within 3-5 years, you would invest those funds in short-term bonds within this layer of your stack. Doing so offers a higher expected return than keeping the funds in the previous layer of the stack while simultaneously limiting price volatility, and potential losses, in the event that you needed the funds sooner. For even longer-term liquidity needs, successive layers invested in longer-term bonds could be added, though at some point the requirement becomes so distant that the funds would be better invested in equities deeper down in the stack.

The final layer (or layers) of the stack is reserved for assets upon which no liquidity demand would be placed for decades or more, such as funds set aside for retirement. These assets would be invested in equities and alternative assets, each of which has a very high expected return but is also highly volatile (equities) or illiquid (alternative assets). Selling these assets at the wrong time could result in a significant loss of capital. Consequently, you would only want to invest in these assets if there were no need for the funds for a long, long time.

Why is the stack a better method of asset allocation? There are several reasons. For starters, the stack is a more comprehensive solution than traditional methods. Because the stack forces you to understand your liquidity needs, it can highlight issues that may otherwise go unnoticed (such as excessive spending) and can enforce discipline and planning, things that are out of scope for traditional asset allocation methods.

Relative to other methods, the stack is much more personal and bespoke. The resulting percentage allocation to each asset class is specifically tailored to each person’s unique financial situation. There are no shorthand rules applied broadly across different situations. As a result, the stack leaves you with an asset allocation this is less abstract and academic and much more practical.

The stack is also very easy to understand. It requires no advanced math and only a basic understanding of the characteristics of different asset classes. Because of this, the stack is more easily and intuitively grasped than other approaches, which may improve adherence to the asset allocation as well.

Contrast the stack with the shortcomings of the other methods. For instance, the 100 minus your age rule of thumb should not be used for someone who has a lot of assets relative to their spending. If it were followed, the resulting asset allocation would have too high a bond percentage (and too low an equity percentage) for someone in that situation while the stack would correctly guide that person to a higher, more appropriate equity allocation.

An income-based method may mislead if you also need to achieve capital appreciation to grow the level of income to keep pace with inflation. Again, here the bond allocation may end up too high, which would impair the prospects for long-term capital appreciation that using the stack could preserve.

Using a growth-centric method to set an asset allocation may cause you to aim too low, particularly if your liquidity needs, as determined using the stack, can support a more aggressive equity percentage than what is needed to reach your future goal.

Using the risk and reward parameter method to set an asset allocation caters primarily to your willingness to take risk, when in fact your ability to take risk, based on your liquidity needs, could be materially higher. Rather, using the stack to set an asset allocation can help you better understand your ability to take risk and also clear up misperceptions about the riskiness of certain assets 7 and, consequently, your willingness to take risk.

Using David Swenson’s portfolio management strategy, which may not even be appropriate for individuals, can in some cases make choosing the right asset allocation unnecessarily complicated and expensive whereas a simpler solution, at a fraction of the price, could be just as good. In that case, using the stack instead could be a better overall outcome, all things considered.

As mentioned at the beginning, this is the final column in a three-part series and intended to integrate all three topics – asset allocation, volatility and compounding – together. Having thoroughly covered asset allocation and introduced the stack, it is now time to make good on that intention. The first column in the series described how volatility has both positive aspects and negative aspects. The stack method of asset allocation is designed to reduce the negative aspects of volatility 8 to position you to take advantage of the positive aspects.

Volatility is commonly perceived as a negative and, hence, something to be avoided. Because volatility is avoided, fewer people want to purchase volatile assets and their price falls. As the price falls, however, the expected return of the assets rises in turn. Thus, those who have arranged their asset allocation appropriately to hold more volatile assets for long periods of time, as using the stack does, should have a higher expected return and better long-term results. 9

A good example of this dynamic is equities versus bonds. Over long periods of time, equities have always outperformed bonds. That this is true would imply that investors should only own equities, such that the price of equities rises and the price of bonds falls until the return disparity between the two is eliminated. The reason that this does not happen is because of the interim volatility of equities, which is far greater than that of bonds. In reality people do not want to deal with this volatility or, if they do, they do not have the proper asset allocation to do so and the long-term return potential of equities remains higher than that of bonds.

The purpose of the stack is to establish the right asset allocation to bear volatility in the lower layers in exchange for a higher expected return. Doing so allows you to realize the benefits of volatility while protecting you from having to sell volatile assets at the wrong time, the primary negative aspect of volatility. The second column in this series described the tremendous power of compounding, the best way to build long-term wealth. The stack method of asset allocation provides a strong foundation upon which compounding can occur. For those seeking to build wealth, one of the most damaging things that you can do is to interrupt the compounding process. The stack is specifically designed to prevent this from happening and to allow your most volatile, highest returning assets to compound without interruption over time. It does this by ensuring adequate layers of less volatile assets higher up in the stack are aligned with liquidity needs, allowing assets lower down in the stack to remain untouched for extremely long periods of time, the perfect setup to maximize the benefits of volatility and compounding.

For those seeking to protect and build wealth, asset allocation is one of the most important decisions that you must make and will have the most significant impact on the final result of your efforts. There are many methods to choose an asset allocation. The best way to do so is specifically tailored to your unique financial situation and incorporates an understanding of the benefits of both volatility and compounding to protecting and building wealth.

Volatility is important because volatile assets typically have a higher expected return, if you are positioned to hold on through all of the ups and downs along the way.

Compounding is important because it is the single best way to build tremendous long-term wealth, if you are positioned to allow it to happen without interruption.

The stack method takes into account your specific liquidity needs to build you a custom asset allocation that will maximize the positive aspects of volatility and enable uninterrupted compounding to your long-term benefit. While nothing is ever guaranteed, the stack puts you in the best possible position to protect and build your wealth over time.

Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.

Written By Keith R. Schicker, CFA

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