How you divide up your investments is called your asset allocation. You could invest in only one or a combination of cash, bonds, stocks and alternatives. The point is that you can control how you deploy your assets. Asset allocation is the most important part of an investment plan. An allocation and how it is managed can have a significant impact on your retirement lifestyle. Here’s our plan for asset allocation:
- Know the purpose of the portfolio. Is the purpose for growth, principal preservation, income, etc.? For what time frame? Two different goals and time frames (funding college in 5 years and retirement in 20) may warrant two different portfolios. The purpose of the portfolio drives its construction.
- Determine an appropriate stock-to-bond ratio. The first step of construction is based on the purpose of the portfolio (what level of returns or income is needed) and personal factors (comfort level, experience, etc.). Risk tolerance is assessed from initial and ongoing conversations, not a one-time questionnaire. The stock-to-bond ratio that is developed serves as the foundation of the portfolio and helps determine its risk level.
- Know what adds value. A mix of an S&P 500 fund and a broad bond fund is a good start, but there are other investments that can add value to the portfolio. Research concludes that both small-cap stocks and value stocks outperform the S&P 500 over time. International stocks and REITs deliver equity returns, but add some diversification. Bonds and alternatives (commodities, etc.) deliver the best diversification to stocks. Bottom line: only add an investment to a portfolio if it increases expected return, or decreases volatility
- Construct a broadly diversified allocation for the overall portfolio. An investor may have multiple accounts, but a single overall allocation should be used to tie them together. This holistic view can reduce confusion, costs, and taxes of managing a separate portfolio for each account.
- Recognize constraints on the portfolio. Constraints such as limited 401(k)/403(b) investment options, taxable positions with low cost-basis, employer stock options, and investments with surrender charges need to be addressed with strategies on a case-by-case basis.
- Determine asset location to maximize tax efficiency. Place tax-inefficient investments in tax-deferred accounts and tax-efficient in taxable accounts. This goes beyond "put bonds in an IRA and stocks in a taxable account". There can be wide variations in tax-efficiency within stock and bond asset classes. Our Asset Class Tax-Efficiency Rankings allow for further fine tuning.
- Select appropriate investment options. Avoid individual securities. Mutual funds and ETFs are much more diversified. Select investments that represent their respective asset classes well. Preferred investments are passive (index funds), very low cost, and have a large number of holdings.
- Implement portfolio in the most cost- and tax-efficient manner. Keep transactions to a minimum (a good portfolio design should do that). Control the tax impact on sales of existing holdings that won't be included in the portfolio.
- Manage it. "Buy-and-hold" investing implies a "set it and forget it" mentality. Allocations can stray and opportunities can be missed with that approach. Instead, practice "buy, hold, and manage." Management requires rebalancing at both the stock-bond level and at the individual asset class level based on certain tolerances. It requires an eye on taxes (what taxable income and gains is the portfolio generating, and are there any opportunities to offset these with losses?). It includes managing ongoing contributions and purchases, or distributions and cash management. Management also includes monitoring performance, implementing certain strategies (withdrawal for retirement income, portfolio constraints, investing cash windfall, etc.) and staying abreast of new research and investment options.