Developing Your Asset Allocation
Creating and managing your asset allocation is one of the most important investment decisions you will ever make. Asset allocation determines the amount of risk in your portfolio, while setting the boundaries of future returns. The chart below shows the estimated risk of various asset classes and the long-term return potential:
|Asset Class||Downside Risk||Long-term Return|
The higher the downside risk for an asset class, the higher the potential long-term return. For example, US equities are expected to fall 50% in an economic downturn (which was exceeded during this recession). The recession also saw US equities exceed the average recession decline of -40%.
But as the economy recovers, investors are rewarded for taking risk with a substantially higher long-term return than safer assets. We expect the future return to be close to the historical number, which is over 10%. In order to reap the benefits of taking more risk, the key is to hold onto the investment through the downturn. Most investors who find they have too much risk sell during the sell-off, and therefore do not earn the long-term return of the asset. This is like buying high and selling low, when they should be buying low and selling high.
To start the asset allocation process consider the following investment objectives to develop a strategy that fits your needs:
- Time Horizon
Examine your timeframe to calculate the optimal amount of risk. A short time period calls for conservative investments while a long time period allows for more risk.
- Return Requirement
Consider where your assets are today in relation to your end goals (such as retirement).
- Risk Tolerance
Investors are comfortable with varying levels of risk. It’s important to identify how much risk you are willing to take. Be honest with yourself: Can you sleep at night with this level of risk?
- Liquidity Needs
Before you begin allocating your assets make sure you plan for upcoming expenses such as vacations or college tuition.
- Tax Consequences
Investors in a high tax bracket should utilize tax efficient vehicles such as municipal bonds, dividends and long-term capital gains.
Developing an asset allocation that you’re comfortable with is the first step to creating an investment portfolio that is tailored to your individual needs. The right portfolio will produce necessary cash flows, create reasonable return for long-term goals and be structured to maximize after-tax returns.