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Picking Asset Allocations

We all have financial goals that we want to achieve in the future, whether it’s buying a house, retiring early, or saving money for a child’s education. But to achieve these goals, you need to invest your money wisely and choose the right asset allocation to suit your personal financial situation. 

Asset allocation is the outcome of the process of dividing your investment portfolio among different asset classes such as stocks, bonds, and cash. The right allocation will depend on your financial goals, risk tolerance, and time horizon among other factors. When choosing an asset allocation, it is important to remember that it is not a one-size-fits-all approach. Every individual’s situation is unique, and seeking professional advice from a financial advisor can be incredibly helpful for most people. 

One of the most common mistakes investors make is taking on too much risk. Just because you may have the ability to take on risk does not always mean you should. Too much risk can lead to abandoning your investment plan and can cause investors to deviate from their original asset allocation strategy or long-term investment goals. This deviation can undermine the effectiveness of a well-thought-out investment plan and hinder long-term success. This is because many investors are loss averse. Loss aversion is a psychological phenomenon whereby investors may be more affected by a loss or a potential loss more strongly than they would be by an equivalent gain. 

You may be wondering how this actually plays out in real time. Consider an investor who is trying to decide how to invest their IRA. They may be considering a conservative allocation targeting a 3% annual return, a balanced allocation targeting a 5% return, or a more aggressive allocation targeting a 7% annual return. They plan on saving $5,000 a year into an IRA all at once in the beginning of the year, and each year thereafter. After five years they could potentially have about $27,342 if they invested conservatively, $29,009 if they chose the balanced allocation, or maybe $30,766 if they chose a more aggressive allocation. That’s only a difference of about $3,400 from the conservative allocation to the aggressive allocation.  Unfortunately though, most of the time markets do not move linearly at the same rate. Of course, no one can provide certainty around market returns and simply targeting a return doesn’t guarantee you will get it, but this illustration is meant to help highlight the differences between taking more risk or taking less risk. 

In the example above, we know the outcome of the portfolios, but we don’t entirely know how they got there. If the market had positive returns for the first two years, then declined sharply in the third year before rebounding in the final two years, an investor may achieve their desired rate of return, but only if they stayed invested and stuck to their financial plan. Many times though we find that investors will pause in times of turmoil and save less than expected or modify their asset allocation. Doing so is a deviation from the plan, and while doing so could be appropriate, it often leads to investors not achieving the goals they planned for on time or at all. Working with an advisor to determine the appropriate asset allocation for your specific needs can be extremely beneficial for your and your individual plan so that you do achieve your goals when you planned for them.