Your Financial Evolution: Asset Allocation (2024)

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Asset Allocation pertains to how you want to divide the total pie (your overall portfolio) with respect to the various asset classes you want to be invested in (i.e. how each class is weighted).

There is no one golden Asset Allocation that is guaranteed to provide the best results. Again it comes down to individual factors that determine whether one asset allocation is more appropriate than the other.

Factors such as an individual’s risk tolerance and age can dramatically change how various assets should be weighted.

Stock Allocation:

One of the first major decisions to be made is how much exposure do you want to have to equities (stocks).

As mentioned in our Stock Primer, stocks have great growth potential but also come with great volatility (something that may not be tolerable when you are relying on fixed income sources in retirement).

A very general rule of thumb is (120- your age) = % of stocks you should allocated in your portfolio (some people have used (100-age) but others have found this too conservative)

• For example: If you are 40 years old, 120-40= 80% stock weighting.

It also general consensus to also geographically diversify your stock allocation geographically:

• Domestic (US)
• International (most recommend 10-30% international)

So for the above 40 year old who has 80% of his portfolio in stocks, 70% of that can be domestic (56% of total portfolio value (0.8 x 0.7)), 30% of that can be international (24% of total portfolio value (.8 x .3))

Bond Allocation:

As mentioned in our Bond Primer, bonds have typically lower growth potential than equities, but less volatility (considered fixed income type asset class)

In the simple and very popular 3 Fund Portfolio championed by the Bogleheads, the remaining percentage left in your portfolio can be solely funded by bonds.

• In our 40 year old example this would relegate Bonds to 20% of the total portfolio value

For the more hands-off approach investor this may be an ideal portfolio as there is very little “moving parts” and it far easier to rebalance when dealing with a smaller number of asset classes.

Alternative Allocation:

This asset class is the catchall for those entities that don’t neatly fit under stocks or bonds

• Real Estate
• Real Estate Investment Trusts (REITS)
• Commodities (oil, gas, precious metals, etc.)
• Private placement investments
• Crowdfunding platforms

Cash Allocation:

Includes savings or money market funds

Safe, stable asset class however suffers from inflation risk (i.e. diminishing value of dollar with time)

There are many ways to construct suitable portfolios with any mixture of the above asset classes.

The White Coat Investor, Jim Dahle, has done a wonderful summary of various Portfolios out in the investing universe.

Where to Place Assets:

1. Tax-deferred Accounts (401k, IRAs, etc)
   • Assets that are tax inefficient (with distributions that typically taxed at your individual tax rate) should preferentially go here
     • Bonds, REITs, real estate holdings, etc.
2. Taxable (Brokerage) Account
   • Preferential place for tax efficient assets (equities with qualified dividends, index funds) that have distributions taxed at a much more favorable capital gains tax rate.

Rebalancing:

As each individual asset class behaves differently in a particular market cycle (which is actually a desired benefit of diversification), the subsequent weighting of that class to the overall portfolio will diverge from your initial assignments.

It is therefore important to continue to monitor your portfolio and periodically rebalance it to bring the assets back in line.

Rationale for Rebalancing:

• Allows one to sell high and buy low (by rebalancing you sell asset classes that have outperformed the others and buy asset classes that have declined).
  • This goes against typical investor behavior where there is a tendency to want to hold on to or buy more of one’s “winners” and get rid of one’s “losers” (buy high, sell low)
    • Recency bias has major influence on this behavior and can lead to investors chasing the market leading to potential bubble type sell offs.
  • Asset classes tend to cycle in and out of favor and every dog will eventually have it’s day in the sun.
    • Today’s losers will eventually become tomorrow’s winners. Better to buy them at a discount now.

Different Ways to Rebalance:

• Time horizon based:
  • After a predetermined period of time (such as annually), a detailed portfolio analysis can be performed to determine the current weighting of assets. At that point rebalancing of the asset classes to go back to the original percentage assigned
    • Pros: Much less hands on/less time consuming
    • Cons: Depending on how the market behaves, assets may be substantially out of desired percent allocation for significant time before any action taken
• Allocation tolerance band based:
  • Sets a tolerance band or percent range that an asset can be in before triggering a rebalancing event (I personally use 10% of the initial percent assigned to find my tolerance range)
    • For instance, using our 40 yr old individual example above with a 3 fund allocation:
      • US/domestic stock. Desired 56% overall portfolio. Can have a tolerance band of +/- 5%
        • This asset can go as low as 51% or as high as 61% before needing to be rebalanced.
      • International stock: Desired 24% overall portfolio. Can have a tolerance band of +/- 2.5%
      • Bonds: Desired 20% overall portfolio. Can have a tolerance band of +/- 2%.
  • Pros: Tighter reign on the assets preventing large deviations from occurring
  • Cons: Can be more labor intensive with more frequent monitoring of how each asset class is performing

Methods of Rebalancing

1. Can sell or buy holdings to bring asset classes back in line
   • Caveat:
     • Be wary of potential transactions costs/redemption fees etc that can erode the benefits of rebalancing
     • Be wary of potential taxable events that occur (if sell a holding for a gain in a taxable account, will be subject to either short term or long term capital gains (if possible sell holdings in a retirement/tax-deferred account to avoid this)
   • Selling one’s “losers” is best accomplished in taxable accounts if possible as you can claim those losses on your tax return to get deduction.
     • Termed “tax loss harvesting“
2. Can channel new money into under-performing assets to bring back into target allocation range.
   • This is the method I prefer and currently use

Key Point:

Remember that whatever asset allocation you decide to construct your portfolio, you should treat all your financial holdings as one whole entity.

You therefore must calculate the combined total of your assets from retirement accounts and taxable accounts rather than treat them separately if you truly want to have your portfolio balanced the way you want.

Superhero Take-home Points:

1. A properly constructed (age appropriate/risk tolerance appropriate) Asset Allocation can provide diversification to increase likelihood of continued financial success throughout all market conditions
2. The goal of every investor to “buy low and sell high” can be implemented by periodic rebalancing
3. Be cognizant of how selling assets can give you the best tax break either by avoiding capital gains when done in a tax deferred account or capturing tax deductions using losses in a taxable account.
4. Do not treat retirement and taxable accounts as separate entities for asset allocation purposes.

What method of rebalancing do you employ for your portfolio? Comment below.

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