Before the market downturn, many people were feeling pretty good about their financial situation. The stock market was at all-time highs, houses seemed to be a gold mine and the job market was stable. This led some to take on more risk and concentrate their wealth into only one or two things. This meant that when things went south the losses were substantial. (Learn more about bubbles and busts in our Market Crash Tutorial.)
Conversely, until 2009, the Yale University endowment hadn't seen a negative year in two decades. While there are many reasons for that, one major reason they have been so consistent is that they have a very diverse asset allocation.
Before individual securities are selected, a decision is needed on what types of securities will be in the portfolio. This is called the asset allocation. It is simply a summary of the amount and types of securities in the portfolio. For example, a common asset allocation for an individual investor would be 60% stocks and 40% bonds.
More detailed asset allocations would be more specific and include more exotic types of securities. For example, at one point, Yale's endowment had 12% domestic equity, 15% foreign equity, 4% fixed income, 27% real assets, 17% private equity and 25% absolute return. While that is clearly not for the typical investor, it's likely that neither is the more common 60/40 split. For any given portfolio to be acceptable, it should simultaneously offer the expected return required to meet your needs, but not exceed your ability or desire to accept the associated risk. While this is easier said than done, here are some things to consider as you try to determine your own asset allocation. (Learn more in Personalizing Risk Tolerance.)
- What types of investments will you include?
For an investment type to be included in your asset allocation it must be available to you. Some of Yale's investment types, such as private equity, aren't an option for the average investor. So disregard them from the start. But more importantly, you need to understand the investments and how they work and what the risks are before you invest in them. This is where a lot of investors become very limited in their asset allocation choices. They may feel they understand mutual funds, stocks or bonds. But going much beyond that they become uneasy, and they should. No one should invest a dime into something they don't understand.
However, to decrease the risk without sacrificing return, consider increasing your knowledge so that other asset types can be included. For example, learning about real estate investment trusts (REITS) might allow you to add a different type of asset into the portfolio.
- What specific asset classes will you include?
Even if you are limited to stocks and bonds, the portfolio can be diversified quite a bit before individual securities are considered. For example, domestic stocks vs. foreign stocks would be a start. Then foreign stocks can be split into developed or emerging economies, and then by country. If foreign stocks are beyond your knowledge and comfort level, stocks can still be classified by company size as in small, mid, and large cap stocks, or by sector type as in energy, tech, healthcare, etc. Bonds have similar breakdowns by country, company size or sector.
- Finding the Right Allocation
Once you have determined the types of investments that could make up the portfolio, then the percentage of your assets in each classification need to be determined. This is where it can get difficult and complicated. The problem is that risk is related to expected return. So the more you invest in risky assets, the more return you might get, but the more losses might occur.
For example, if you invest in all high grade bonds, you'll have a fairly safe return. However, that return may not be enough to fund your goals. On the other hand, if you take the risk required to try to obtain your goals and invest in all stocks, you can face market downturns like the recent one we are all too familiar with. The balancing act is difficult for everyone, which is one reason the 60/40 portfolio is common.
To find the right asset allocation for you, start by reducing the risk avoiding concentrating all your assets into one thing. Then make sure you understand what all your options are that are capable of investing in. Then consider how much risk you are willing to take to try to get the return you desire. The more risk, the more you lean toward stocks and riskier investments. The less risk, the more toward high grade bonds and treasuries. The balancing act isn't easy for anyone and following the hot trend comes natural. But it's wise to learn from the Yale example, and diversify your asset allocation. (Learn more in Five Things To Know About Asset Allocation and Achieving Optimal Asset Allocation.)