Asset allocation is the proportion of your total wealth in different asset classes. It is important to get your asset allocation right for your individual situation and ability to handle risk. Diversifying amongst different asset classes allows you to spread out your risk and smooth out your portfolio returns. Risk and return are strongly related in all investments. So, you want to choose enough risk to get high enough returns to meet your objectives. However, you want to balance that with enough “safe stuff” that the fluctuations in your portfolio don’t cause you to freak-out, sell at a bad time, and blow up your plan. This page is built to help you systematically consider the important factors and end up with a basic asset allocation plan for your DIY investing.
I am not a qualified investment advisor. So, none of this is specific financial advice. These are tools for you to use to help you figure out what to do for yourself. That is vital as a DIY investor and/or if you are using a financial advisor. If you are DIY’ing, then you are responsible for your decisions. If you are using a financial advisor, they should help you with this aspect of investing (it is what you are paying for) but you are still the one ultimately responsible for the outcome.
Basic Definitions & Commonly Used Terms
An asset class is a group of investments that share similar characteristics in terms of risk, volatility, expected return, and factors that influence those.
The simplest asset division in DIY investing is stocks (equity) and bonds.
Equity is owning a part of a company . The value of that share depends on the assets the company owns and its future earning potential. Future earning potential is constantly changing which makes equities have more price fluctuations (volatility). Profits are only limited by how much a company can grow them and a company could also go bankrupt. So, there is higher risk and higher potential return.
Bonds is owning debt. The upside potential is more limited than equity. If you hold a bond to maturity, you don’t get more than the interest rate payments. Bonds can fluctuate in price before they mature, but that tends to be much less than what you would see with equity. Risk and reward still applies to bonds and bonds that pay more interest also have higher risk of default. The lowest risk debt are government bonds from developed countries. The price of government bonds generally fluctuates on a different cycle than equity – often in the opposite direction. So, bonds can help to dampen the price swings in a portfolio. That makes it easier to sleep at night and stick your plan when the markets are in a funk.
More complex asset division of asset classes.
You can split equity or bonds into all sorts of subgroups. That could be based on geography or industry group. It could be on characteristics (factors) that carry a different degree of risk and expected return such as size, value, profitability, quality, or how aggressively they invest.
There are also other alternative asset classes that you could include as part of your overall portfolio such as directly owning real estate, a business, intellectual property, private equity funds, or collectibles.
When considering alternative investments or slicing and dicing your asset allocation, consider whether the increased complexity is worth it or not. It likely is not for the average investor starting out. Also remember that the relationship between risk and reward still applies – if it sounds too good to be true then you are missing something.
For getting started with DIY investing, we will stick with a simple stock:bond ratio for asset allocation. A simple plan that you execute and stick to is better than a complex one you don’t. You can always make it more complicated later when you are more experienced and have a bigger portfolio. Don’t feel like you are missing out. The benefits of more complexity are marginal (at best) compared to more time in the market, low fee-drag, and an automated strategy that is less prone to behavioural errors.
Risk Capacity & Risk Tolerance
Your risk capacity is your objective financial ability to take risk. That means your ability to absorb an investment loss. There are a few major factors that contribute to this.
Your risk tolerance is how much you can watch your investments fluctuate without it causing you to deviate from the plan. That means not chasing a bull market by mortgaging the farm to buy more and not panic-selling in a downturn. It is about emotion and behaviour.
Multi-Modal Approach To Finding Your Asset Allocation
There are multiple ways to look at both risk capacity and risk tolerance to come up with an asset allocation.
Each method has different strengths and weaknesses – so the more we use, the better. The methods are based on historical data. That doesn’t predict the future, but it is the best we have. Both our risk capacity and risk tolerance will change as we move through life.
If you want, you can just do the Vanguard Risk Tolerance questionnaire. That is a quick tool that asks a few questions and spits out a stock:bond asset allocation. That is a great way to get a start point and for those looking to just get started. For those who want to take a more comprehensive dive into assessing their ability to take investment risk, I created this section of pages.
Here is an overview of the approach that we will cover in this series of pages.
It is an art and not a science. Even though we use numbers.
The returns that we use are historical numbers and are extrapolations from what our portfolio would have done. That is not precise and does not predict the future. We then reflect on those numbers and image how we would react to them.
Risk tolerance is based on emotion and behaviour. Emotions are impossible to avoid – we have them. Behaviours are hard to control, but we can educate ourselves and set up an approach to maximize our chances. Accurately and precisely predicting how we will react to something we have never experienced before is impossible. Even when you have invested for years and experienced multiple bear markets, each one is different and is driven by some other major event that permeates our lives. Wars. Pandemics. Financial Crises of different flavors. We will do our best to estimate our risk tolerance, but it is an estimate.
The good news is that you don’t need to be super precise. The difference between 60:40 and all equity is likely important. The difference between a 60:40 and an 80:20 or 50:50 stock:bond portfolio is likely within the error of our imprecise tools. We do our best and then adjust. That is ok. The missed time in the market agonizing over 60:40 vs 80:20 is probably worse than just picking one and adjusting.
The lowest of your risk capacity or tolerance is what should determine your asset allocation.
For most people, particularly young people with a long investment horizon and high-income people, their risk capacity is much higher than their risk tolerance. However, that is a generalization and exceeding either can be disastrous. You need to keep an asset allocation with the risk level within both your risk capacity and your risk tolerance.