Folks often wonder, what’s the primary driver of long-term wealth accumulation? In terms of investing, you generally want to buy low and sell high. While it’s undoubtedly true you don’t want to overpay for an investment, or sell it below what it’s worth – “buy low sell high” often leads people to attempt to time the market. Studies have shown that attempting to time the market typically leads people to actually “buying high and selling low” – not exactly the outcome we should be looking to achieve.
So, the most important driver in reaching your financial goals isn’t timing the market, it’s time in the market – and routinely the thing that most drives a person’s returns is something called asset allocation.
As its name suggests, asset allocation is the collective percentage of a portfolio allocated to each asset class. For example, a “60/40” portfolio has 60% of its assets in stocks and 40% in bonds.
Studies have shown that asset allocation may account for upwards of 90% of a portfolio’s long-term returns. In short, the percentage of assets allocated to equities vs. non-equities is the principal factor of portfolio performance over time.
Traditional asset classes fall into two broad categories: equities (stocks) and non-equities (bonds and cash). A third type, Alternative investments, represent a non-traditional category in many modern portfolios. These broad asset classes consist of multiple ‘sub’ asset classes. For example, large-capitalization U.S. equities and international equities are sub asset classes within the broad equity asset class. U.S. Treasury notes and investment grade bonds are sub asset classes within the broad non-equity asset class. Managed futures and long/short strategies are an example of sub asset classes within the broad alternative asset class.
Generally speaking, asset classes with the greatest upside potential also have the greatest downside potential. This is known as risk premium – meaning that over time, investors should be rewarded relative to the risk they assume. Effective asset allocation can also insulate portfolio returns from excess volatility. This can be achieved by allocating assets with respect to the correlation of each asset to other assets within the portfolio.
What is correlation? It measures the degree to which assets move in the same or opposite directions. This measure ranges from +1 to -1. Assets which are positively correlated move in the same direction, while assets which are negatively correlated move in opposite directions. Assets which have no correlation do not move in relation to each other. By allocating a percentage of capital to negatively or non-correlated assets, one can reduce the volatility in their portfolio.
But, how do we determine proper asset allocation?
As I mentioned earlier, equities may offer the best potential for growth, but they can be volatile during that process. Conversely, while non-equities may offer the best potential for capital preservation, their returns often underperform equities over extended periods. Therefore, a suitable asset allocation must be tailored to an investor’s specific time horizon, risk tolerance, and investment goals.
Ultimately, an investor’s time horizon will have a large impact on their portfolio’s asset allocation. For example, an asset allocation suitable for a young professional at the start of their career is not necessarily suitable for a person who is nearing retirement. For those who have long investment time horizons, higher allocations to equities may provide better potential for growth and wealth accumulation. For those with shorter time horizons, higher allocations to non-equities may provide better potential for stability and wealth preservation while potentially generating current income.
Equally important to an investor’s asset allocation is their risk tolerance. This often varies greatly from person to person. If an investor has a low tolerance for risk, a portfolio with a smaller percentage allocated towards stocks and a greater percentage allocated towards bonds may be more suitable. Conversely, a portfolio with a greater percentage allocated towards stocks and a smaller percentage allocated towards bonds may be more suitable for an investor with a high tolerance for risk.
To sum up, asset allocation is a primary factor in determining an investor’s long-term return. Studies have shown that it can possibly determine for up to 90% of your returns. It can help align your risk/reward profile by helping you achieve the maximum return while accepting a minimal amount of risk. In short, asset allocation is about wisely using your time in the market, not trying to time the market.