What Does Your Asset Allocation Really Mean?

I want my money to grow as quickly as possible with as minimal disruption as possible along the way.

That's what everybody says, right?

Based on hundreds of conversations with investors, most tell me they've been surprised once or twice along their investing journey. Generally, surprises aren't an enjoyable experience for investors.

The market continues to confuse even the experts. However, many investors could have a better experience if they had a proper expectation of risk and return.

Risk are return are directly correlated to an investor's Asset Allocation. To determine asset allocation, most investors start with a questionnaire. These short quizzes attempt to gauge how an investor would react in various hypothetical market environments. For example, if the market lost 20% over the course of 6 months would you 1.celebrate, and rush in to buy more stocks, 2. do nothing, you never look at your statements anyway, or 3. sell everything in total frustration, then go find some puppies to kick?

The problem with these questionnaires is the results can be skewed by recent market experiences. Research suggests investors are more confident during bull markets and less confident during bear markets. This bias can negatively influence how we answer hypothetical market what-ifs. If we end up with too aggressive an allocation, we might not be able to emotionally handle big market dips. That's bad! If we're too conservative, our portfolio might not survive through retirement.

As you can imagine, we're going for the Goldilocks effect here.

Let's say based on your risk questionnaire results you selected a 60/40 "balanced" portfolio of stocks and bonds. Do you know how this portfolio behaved in the past? Do you have a correct expectation of how the portfolio will Compound Over Time?

If you said "uhhmmm", check this out.

I ran a hypothetical 60/40 historical scenario in my Morningstar research software using the following index construction: 36% S&P 500, 24% MSCI EAFE (International Stocks), and 40% Barclays Aggregate Bond. Dividends and capital gains distributions were reinvested, and I assumed annual rebalancing. The starting point was 12/31/1975, and the analysis ended 12/31/2015.

Cumulatively, this hypothetical portfolio returned 2,770.73%, or 8.75% when averaged annually. To put these return numbers in perspective, if you invested $100,000 when you were 25 years old and let it ride for 40 years until retirement, you'd have $2.87 million*.

Sounds good so far, but what about volatility? Volatility can be thought of as the price of admission to the long term growth show; it is the utter annoyance of declines as well as the jubilation of double digit growth.

Historically, a balanced approach has experienced more volatility than most investors realize. The hypothetical 60/40 portfolio saw some pretty big short term swings. FYI, 1-3 years is still a short period of time, relatively speaking.

So if you're that hypothetical 60/40 balanced investor, does this information help you? Do your palms get a little sweaty looking at those Worst % figures? Do you think you could actually stay cool and committed even after three years you were still down -7.04%?

Still want that return without the risk? Since you're a savvy investor, you know it's not going to happen (and you'll never be tricked into any investment that promises return with no risk). But let's say the thought of watching your portfolio dive -18.16% in just three months still makes you squeamish. I have a solution to help keep you focused on sticking to your asset allocation. And here's why you want to do that.

What I've found is investors who engage in a Comprehensive Financial Plan approach asset allocation in a very sensible way. These investors have clarity on what it's going to take to reach their goals. As such, they know a certain asset allocation (with involves some risk) is necessary to mitigate the future risk of running out of money. Knowing they require a particular asset allocation helps them stay committed when the going gets tough.

Unlike justifying eating a bag of cookies just because you worked out this week, financial planning validation is actually good for you! An investor who understands the appropriate amount of risk within the context of their big picture goals is an investor less likely to panic sell during a decline.

Financial plans to calm investor nerves isn't just my idea. After I wrote this post last week, I came across a New York Times Article suggesting the exact same thing.

It's rare that you should ever tinker with your asset allocation. But, that statement is premised on the idea that you got it right in the first place. Before you go back to whatever you were doing, take a moment and ask yourself what asset allocation you signed up for? If you can't remember, now is a great time to chat with a financial advisor about your current investment design.

If understanding your asset allocation and its historical perspective has become important to you, use the Shoot Us An Email form in the website footer just below. Doing so will initiate a personal email response from me. If you like, I'd be happy to look at your holdings and generate an unbiased summary. No strings attached. Your summary can help you approach asset allocation on your own. Or once you're comfortable, hire us to help you!

* This hypothetical scenario is based on indices. Indices are not available for direct investment, and therefore do not represent an investor's actual returns. If an investor used actual index funds in a real investment scenario, they'd have slightly less than the hypothetical example due to fund expenses and trading fees.

#investorbehavior #assetallocation