2016 was an interesting year for the markets, as many industry “experts” predicted; it was in truth a very volatile year for the markets. As many scrambled to react to this correction, the investors with a plan ignoring the noise and sticking with their long-term strategy of having a risk-based, properly diversified asset allocated portfolio.
This market rally occurred in one single day and those whose strategy is to time the market may not have shared in this gain. As these market-timers would deliberate on when to get back into the market, they could once again find themselves among the masses of emotional investors “buying high” as the market continued to swing like an erratic pendulum. The point here is that the notion of timing the market versus time “in” the market may not be an optimal long-term investment strategy; however, here is the kicker, that is only part of the story…
One of the facets of investing that is often overlooked is the concept of Asset Allocation. Not ignoring that fact that there are several other factors that play a role in successful long-term investment strategies, the role of Asset Allocation is to align one’s resources to their risk tolerance and to ensure that the portfolio has exposures to several asset classes so as not to rely solely on one specific asset class. Given that it is virtually impossible to consistently predict which asset class will be the “winner,” having a well-diversified and risk-based allocation can greatly reduce volatility while capturing near market returns over the long term.
So now that we have an understanding of the ‘why,’ let’s dive a little deeper into the ‘what’ and ‘how.’ The term asset class refers to a group of securities that have similar financial characteristics, behave similarly, and are subject to similar market forces, laws and regulations*(2). The most commonly discussed asset classes include: equities (stocks), fixed income (bonds), cash/ money market instruments, and real estate. As one might conclude, an asset class does not follow ay particular pattern year over year, making it nearly impossible to predict what the next year will bring.
Now for the ‘how’… Asset Allocation is not rocket science, but it does require some knowledge of how each asset class affects its counterparts in a diversified portfolio. So what does this ‘secret recipe’ look like? Well that depends on your appetite for risk as it relates to the overall market. Below is a general guide of what a conservative, moderate, and aggressive portfolio could look like. As investing is very personal and should be specific to time horizon (short, intermediate, and long- term) combined with a stated goal (preservation, accumulation, and income), it is not uncommon for investors to have several portfolios allocated in a matter that suits each account’s purpose or goal.
Rebalancing also plays a critical role in Asset Allocation and serves several purposes. Many professionals would agree that there two important factors that advocate for rebalancing your portfolio. The first reason to rebalance is to help ensure that your portfolio does not drift out of your risk tolerance. As markets rise and fall throughout a calendar year, it is understood that certain sectors will outperform others in a given market cycle. While it is preferable to have positive gains, it is critical to keep in mind that your portfolio weighting may no longer be in line with your risk tolerance/ profile. The second compelling reason to rebalance your portfolio is, that as sectors in your portfolio will either perform or underperform their benchmarks- one is able to take advantage of a disciplined approach of “buying low and selling high.” For example, let’s say that the Large Cap exposure in your portfolio is down and your Emerging Markets (EM) exposure is up, an annual rebalance will now position you to take the gains from Emerging Markets (selling high) and purchasing more of the Large Cap (buying low). It is for these reasons that that rebalancing your portfolio is a critical component of a sound investment strategy, and that keeps true to your risk tolerance.
In order to determine what allocation suits you best, it is always good practice to seek a professional opinion (or a second opinion for the do-it-yourselfers out there). In addition to considering risk, time horizon can also help guide the right allocation given the goal of that specific account.
In conclusion, when discussing portfolio construction with your advisor, make sure you understand how he/she will go about setting the right allocation for your portfolios’ goal. Key talking points include (but are not limited to): discussing the difference between using active and passive investments, internal expenses, time horizon for the money and last but not least… your risk tolerance.
*(2) Asset Class definition (Wikipedia, https://en.wikipedia.org/wiki/Asset_classes)
Diversification helps you spread risk throughout your portfolio, so investments that do poorly may be balanced by others that do relatively better. Neither diversification nor asset allocation can ensure a profit or protect against a loss.