Beginners’ Guide to Asset Allocation

Most people have heard the term asset allocation even if they aren’t investors themselves. It’s a term that gets used frequently when planning your finances and investments so it’s a great idea to have some idea of what it means and how it might apply to you – even if you don’t own any investments at all!

What is Asset Allocation?

Asset allocation refers to the relative amounts of various assets that you own. For example Susan might own a house, a car, have a 401k with her employer and keeps some cash in the bank. What is her asset allocation?

If her assets have the following values:

  • house – $200k
  • 401k – $40k
  • car – $10k
  • cash – $10k

then their total assets is equal to $260,000. Normally you talk about asset allocation in terms of percentages of the total – so for our example Susan would have the following asset allocations:

  • house – 77%
  • 401k – 15%
  • car – 4%
  • cash – 4%

From these numbers it is clear that this person has a high weighting of real estate at 77% (their house) and a low weighting of cash (only 4%).

An important term to learn is asset classes – these are assets that are similar enough that you would group them together when talking about asset allocation. For example if you own two different stock mutual funds then you might just lump them together in your “stock” allocation.

What about Investment Asset Allocation?

Ok, so now we’ve covered what asset allocation is and how it applies to any kind of assets we might own – let’s take a look at investment asset allocation.

One of the key things to know about asset allocation with respect to your investments is that there are different levels from general to specific. It’s easy to get confused when someone asks you a very specific asset allocation question like “How much do you have in junior oil players?” when you can’t even remember the name of your investment company! The best way to analyse your asset allocation is to look at your portfolio at a very general level and then only worry about the specifics later on if you feel it is necessary.

The most general investment asset classes are stocks, bonds and cash. These don’t have to be owned directly – most people own stocks and bonds indirectly through a mutual fund or exchange-traded-fund (ETF).

Some general investment asset allocation examples

Here is an example of a general asset allocation:

  • Stocks – 70%
  • Bonds – 20%
  • Cash – 10%

In this case, the investor has a high (70%) allocation in stocks which indicates that they are a fairly aggressive investor since stocks usually go up in down more in value than bonds and cash.

If you were to look at that investor’s account statements, they would probably own several different investments that fall under the “Stocks” category – since we are just looking at the general asset allocation we would just lump all the “stock” investments together.

Here is another asset allocation example of a more conservative investor:

  • Stocks – 30%
  • Bonds – 50%
  • Cash – 20%

In this portfolio, there are a lot less stocks and more cash so this portfolio probably won’t be as volatile as the more aggressive example.

What is the Point of Asset Allocation?

The main purposes of figuring out your asset allocation are:

  1. Knowing what you are invested in. If you have 90% cash and CDs then your portfolio is very conservative and you are unlikely to lose much money. You are also very unlikely to make a lot of money. If this is not what you want then it’s time to make some changes.
  2. Diversification. If you own a lot of different mutual funds then it is hard to know what they all contain. By going through and figuring out what types of industries and stocks they invest in – you can see if your portfolio is diversified or if you have 90% of your portfolio in junior oil stocks.
  3. Investment time horizon. If the money in your investment account is intended for retirement and that is many years away – then you can have a higher allocation to stocks since you have time to make up any losses. If the money is for next year’s vacation – then it better be in something very safe such as CDs.

Photo by borman818.

10 thoughts on “Beginners’ Guide to Asset Allocation”

  1. I must agree with your insights. It is really important to have something readily available for the rainy days than having all your money in investments.Keep a portion in your wallet.

  2. “Hands down” means the same thing as no contest, meaning, index funds will nearly always beat actively managed funds, and the few times actively managed funds do beat index fund performance, it’s purely luck, not skill.

    There was a great NYT story on the subject recently, but this is a widely repeated maxim.

  3. Hi Fern – I don’t think it’s exactly true that index funds beat managed funds hands down – it’s more of slight lead on average.

    I’m not saying don’t buy index funds – I love them but don’t expect miracles!

  4. I’ve begun some major tweaks to my portfolio. After reading story after story that index funds beat actively managed funds hands down due to lower annual expenses, I finally moved money from my T. Rowe Price Small Cap Value and Small Cap Stock funds to a single Vanguard small cap index fund.

    Ultimately, i want my entire portfolio to be 100% index funds. the bond component of my portfolio is in an index fund, and so are my large cap stocks and my foreign stocks, but i also have a mid cap fund which is not. Have to figure out what to do with that. It’s a taxable fund, so would be a pain to sell and have to deal with the tax consequences unless i put it in a very similar mid cap index fund.

    Thoughts?

  5. Good post!

    The early example you gave made me think of a post I had done about people having too much of their net worth in an illiquid asset– their house.

    I know people who have few financial assets and when asked about their nest egg, will point at the ceiling and say, “The House!” This problematic because you can’t liquidate part of the house to pay your expenses.

    They are painted into a corner because they really only have three options to access the cash:

    Sell the house– not a good option, if you need or want to live in the house

    Get a home equity loan– not always easy or attractive when you are retired on a limited income

    Do a reverse mortgage– not very attractive either, usually filled with fees and charges

    The answer is be sure to build liquid financial assets outside of your home . . . cash, brokerage accounts, retirement accounts, etc.

  6. I’m super old-fashioned and in my opinion, its good to be cash-heavy in an economy such as this. I invested what is supposed to be the suggested dollar amount per a 30 year old person to have in order to retire by 60 last year, which is surprisingly not a huge amount. I’m not touching it despite the performance of late.

    But the bulk of what I have otherwise is cash for a number of reasons.

    A: the US dollar is still deemed safe, hence other countries are still buying and using dollars.

    B: Assets- aka, houses and cars are getting cheaper. The typical American has no savings and relies heavily on aggressive borrowing to consume, which in turn means they are more reliant on their home’s value than their investments or actual savings. In a recession, these people lose the bulk of their purchasing power as the price of homes goes down and banks refuse to loan to them. But for those who save, they have a better position and can use their savings as leverage to buy at lower prices.

    C: Obviously having lots of cash is pretty safe.

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