Understanding Asset Allocation Strategies

According to a recent Gallup poll roughly half of all Americans do not own any investments, which makes it hard for them to achieve financial empowerment for reasons we’ll delve into. If you read the last post and you’re hopefully committed to being in the other half of this statistic and you're ready to start diving into asset allocation strategies.

Again, please note I’m not a financial advisor and the purpose of this article is to be educational. You should continue doing additional research on your own and consult your own advisors when adulting!

Before we start randomly buying stuff, we need a strategy. A proper plan depends on factors including your age, risk tolerance and financial goals. This article is written aimed toward people who are 30ish and have already taken some preliminary steps to be financially healthy before starting their investment journey. If you don’t fall into that bucket, you could still benefit from learning some common terms and concepts, so please stick with me.

First, recognize that investing involves taking risk. The reason you can potentially earn attractive returns from investments is because you are essentially being compensated for taking that risk. We can mitigate risks with sound strategies, but we can never eliminate it. Although historical returns can be a positive indicator of future success, it’s not a guarantee. 

We’re going to start with a basic strategy that mostly consists of cash, stocks, bonds and alternatives. The goal is to create a diversified portfolio of assets to meet your financial goals with tolerable amounts of risk. Before we talk about the proportions of each asset class, here are some definitions so we all stay on the same page.

Cash = Currency that can be exchanged for goods and services. For the purposes of this article, we’re just talking about US dollars for now.

Bonds = These are fixed income assets you (the investor) purchase from a borrower (a company or the government for example) in exchange for an agreed upon amount of interest over a period of time. One advantage creditors (you the lender in this case) have over equity holders (which we’re about to go over) is that in the event of a default, they get repaid first. Bonds are generally viewed as safer than stocks for this reason and also because many bonds are secured by assets that can be liquidated in the event of a default (when the borrower can’t repay). For example, if you loan money to a builder to erect a home and they default, they may have pledged the land and construction equipment as collateral that can be sold to repay you in full or at least mitigate your loss.

Stocks = When most people think of investing, they tend to think of stocks. When you buy stocks, you are issued warrants that represent ownership in the company. Companies sell their stock (and also bonds above) to finance their operations. When you buy stocks, you’re considered a shareholder because you share in the company's profits. This doesn’t mean you always get a payout if there are profits. Many companies, like Apple for example, chose to retain profits so they can invest them in research and development or expansion in the hope they can generate even greater returns in the future. 

Alternatives = These are generally assets that are not stocks and bonds. They can include anything from baseball cards, metals like gold or silver, cryptocurrencies or residential estate. Alternatives tend to be less liquid (which means they could take longer to sell) and are more difficult to value since they are being bought and sold less frequently.  

Okay, we have some shared language, we know we need to accumulate some of these assets, but how much of each do we get?

This part is subjective and again depends on your time table and risk appetite. In general, when you’re younger and plan to be invested for 30+ years, you can take a very aggressive strategy that includes assets with more risk and higher returns, like stocks. As you get older, you may not be able to weather a bad year or a string of bad years, so you would reallocate your investments over time into relatively safer assets with lower returns, like bonds. 

One method David Welliver, founder of Money Under 30, uses that I like is starting with 100 - your age. For example, if you’re 20 using this strategy you’d be 80% in stocks and 20% in bonds, and if you’re 60 you’d be 40% in stocks and 60% in bonds.

It’s a good idea to leave some percentage of your portfolio in cash so you can take advantage of opportunities that might come up. For example, after the tech bubble burst in the early 2000s, savvy investors who believed the long term growth trend of the internet was going to continue were able to buy more tech stocks at depressed prices and position themselves well for the future. They didn’t know which ones would go bankrupt and which ones would succeed, so they diversified by buying a basket of all the stocks, known as an index. The most popular technology index is called the Nasdaq. Although it got hammered in the early 2000s, it’s now trading at more than 3x its peak at the height of the tech bubble.  

Like cash, alternatives should also make up a small percentage of your portfolio. Alternatives are great because they tend not to be correlated with the stock market and bonds so they can help protect your portfolio if there’s an economic shock (like the 2008 financial crisis) that broadly depressed most asset class prices. There has never been a time in history when unaccredited investors (people who aren’t super wealthy) could access more types of alternative assets as the rise of fintech companies and deregulation have democratized access to anything from investing to wine, art, sneakers, and real estate. 

Following the aforementioned strategy, a young investor’s portfolio should look something like this below.

This is a very general strategy and each of these broad categories consists of subcategories to be truly diversified. This sounds like a lot of work, but now a days using exchange traded funds, or ETFs, it costs less and takes less time to diversify effectively. We’ll delve more deeply into the actual mechanics of building the portfolio in the next segment. We will also discuss why in today's economic environment, you likely do NOT want to pursue a traditional asset allocation strategy like the one we just talked about!

In the interim, take the next step toward financial empowerment by understanding the breakdown of your current portfolio, if you have one. This will help you gauge where you’re at so that as you learn more you can consider making adjustments. Most platforms track this for you automatically in your portfolio if you have all your assets in one spot already, but if not there are some good tools here to help you.

Thanks for joining me and keep sending me topics you’d like to see covered, as well as any feedback. My goal is to make these helpful and easy to understand, so especially tell me if any parts were confusing so I can clarify points in future segments. If you’re enjoying the series, please tell your friends so they can read along as we continue this series!

Jason Crystal

Sources

https://news.gallup.com/poll/266807/percentage-americans-owns-stock.aspx 

https://www.investopedia.com/terms/b/bond.asp#:~:text=A%20bond%20is%20a%20fixed,(typically%20corporate%20or%20governmental).&text=Bonds%20are%20used%20by%20companies,or%20creditors%2C%20of%20the%20issuer. 

https://www.nerdwallet.com/article/investing/what-is-a-stock#:~:text=A%20stock%20is%20a%20type,up%20in%20value%20over%20time.&text=A%20stock%20is%20an%20investment,that%20company%2C%20called%20a%20share. 

https://www.investopedia.com/terms/a/alternativeassets.asp 

https://www.moneyunder30.com/asset-allocation-for-investors-under-thirty