Broker Check

How To Slice Up The Pie of Asset Allocation

| June 26, 2017
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Today, we’ll talk about the three basic principles to help you understand asset allocation, risk tolerance, and how you can go about creating a diversified portfolio that balances risk tolerance with a desired asset allocation.

Many physicians tell me that they have never received business lessons in medical school. Let’s dive right into class and get going.

What is Asset Allocation?

What does this mean?

To sum it up in a few words… 

Asset allocation is the way that you select your investments.

Asset allocation is meant to help match different kinds of investments to help you be diversified.

Think of the investment world as a big Asian buffet…

You could get the salad bar, war wonton soup, sautéed veggies, dumplings, fried rice, tempura, sushi, sweet and sour pork, kung pao chicken, and lots of other dishes. (I’m getting hungry!)

Some people have preferences for veggies and sushi while others prefer fried rice and dumplings. Each person has different tastes, just like they have different objectives and goals they want to hit.

There isn’t any one asset allocation that can fit all people.

Reflect on these questions for a little bit…

Are you invested into stocks or bonds? How much do you have in stocks relative to bonds? Are your investments here in the US or international investments? How much do you have in US investments relative to international investments? Are they older companies or newer companies?

How much risk are you taking with your principal? What risks are you subject to?

How can you protect yourself against some of these risks?

This may feel a bit overwhelming. Maybe you feel like this my little 6 daughter, stomping around, pulling her hair in frustration, and screaming at the top of her lungs…

It’s All About The Risk. Find Out Yours.

The first step that most folks need to take is to fill out and complete a risk tolerance questionnaire. Our looks like this…

This is a helpful initial determinant. Most risk tolerance questionnaires will ask questions about your time horizon, how much of a loss you can tolerate, and what your outlook is for investments and the economy.

I usually think of risk on a scale of 1 to 5, 1 is the most conservative while 5 is the most aggressive, and everything in between. I usually associate a moderate risk tolerance as a 3, smack dab in the middle.

Like they say in those infomercials… BUT THAT’S NOT ALL!

Financial advisors will also take into consideration your goals and when you want to accomplish them as well. This can vary by client or even by the type of account.

For example…

Let’s say you have a kiddo going off to college next year and you are going to be needing 50k out of the 100k you have invested in a joint account.

 The risk tolerance may likely be fairly conservative for the account you want to withdraw this from even though you may not be retiring for another 10 years.

In this scenario, your retirement accounts may have a completely different risk tolerance than your joint account because you’re not going to need the money any time soon.

Another common scenario where risk tolerance may need to be tweaked is when a client holds a lot of the stock of the employer. Many of my clients hold 3M and Microsoft stock that they get through stock awards and options- it can be worth tens of thousands or even hundreds of thousands of dollars. We may need to be more cautious in their brokerage account due to this risk exposure.

To Actively Manage or Not, That Is The Question

Beyond these basic concepts, consider how you actively you want your assets managed.

Would you rather have your advisor be proactive adjusting the risk exposures regularly or instead every once in a while?

To fit either of these situations there are two types of asset allocation that most advisors focus on- strategic asset allocation and tactical asset allocation.

Strategic asset allocation doesn’t change very much, it is fairly static. For example, a moderate risk tolerance may have a mix of 60% stocks to 40% of bonds. The advisor may change a manager here and there, but the mix of stocks to bonds doesn’t change very often unless the risk tolerance of the client changes.

For the purposes of this discussion, I am assuming ‘alternative’ asset classes such as precious metals, commodities, real estate, shorting the stock market, and volatility investments are considered stocks or ‘riskier’ asset classes as I like to call them.

Meanwhile, tactical asset allocation can change very frequently. They are trying to be proactive in managing one risk or another. For example, the manager may be concerned about interest rates going up, so they may be shifting from long-term bonds to short-term bonds or to stocks.

Or alternatively, the manager may be more concerned about a recession and will put more money in US Treasury bonds or other investments that are perceived to be safer and instead put less money in stocks.

The Application

Now that you know all this lovely information, how do you apply it?

Let’s say that you are looking through your 401(k) choices and you have a menu of choices, you see some performance data, but don’t know a whole lot about the investment options. You can’t tell what kind of investments they are.

I may be a… (ahem) little…. biased (just a little)… but I do think talking to an investment professional may help you evaluate your options, particularly when you aren’t sure about all this investment stuff and know you could need some guidance.

However, if you would rather do it on your own, first find out your risk tolerance, which there are tons of tools online out there to do that, and evaluate your goals and objectives particularly with respect to timeframe.

After you have all this figured out, one major resource I point folks towards is Morningstar.com.

You can look up practically any mutual fund or widely traded security. Categorize each of these investments and understand on a scale of 1 to 5 how volatile they can be.

How did the investments perform in the downturn that started in late 2007 through early 2009?

Then, also consider how they did in the recovery that started in March 2009 and continued through mid 2017?

If they went way down in the downturn and then way up in the upturn, this may be a volatile investment and vice versa if it was a smoother ride.

My general rule of thumb is never to have more than 20% in any one investment and that each investment should have a completely different objective and go up and down for different reasons. Your individual financial situation may differ.

For example. emerging markets stocks will go up and down for different reasons than large cap US stocks which goes up and down for different reasons than US Treasury bonds which goes up and down for different reasons than investment grade bonds.

Additionally, be careful among bonds as some bonds are more sensitive to changes in the economy than others. For example, junk rated or hi-yield companies are rated a poorer credit risk (meaning more likely to go bankrupt) than investment grade companies and can be more volatile. Sometimes, in periods of higher risk, they can act more like a hi-yield stock than a bond.

How does this work in practice? I suggest a mix of international and domestic investments. Or – After an evaluation I may suggest a mix of international and domestic investments for both conservative and moderately aggressive risk tolerances.

 Hopefully, you have a choice of international bond and stock investments as well as domestic investments.

Let’s focus on one example- let’s say you are a conservative investor- I’d suggest selecting less volatile investments with a smattering of more volatile investments. A typical mix of strategic asset allocation for a conservative investor is 40% equities to 60% bonds.

I used to believe that you should aim for at least 25% of the total mix having an international component of both emerging and developed markets within stocks and bonds.

I also used to believe having at least 10% of the total asset allocation mix to be in ‘alternatives’ like we mentioned before- like precious metals, commodities, real estate, etc was important.

I now believe that this is OUTDATED and that there are better ways to invest. My previous suggestion to invest in these asset classes has decreased as US companies have become more and more global. Heck, 50% of most company’s sales are from overseas.

Also, these roads we travel of these alternative investments are wayyy too bumpy and can lead you to vastly underperform the domestic indices. In a future post, I will outline our ‘sector rotation’ strategy and why I think that’s a better fit than the usual ‘alternatives’.

Keep in mind this is one particular example. Make sure you understand YOUR risk tolerance, investment objective and individual financial situation before making any investment decisions.

Feel free to give me a call or e-mail me if you have any further questions. Also, if you would like to go through one of the exercises we have described above or to have a personal financial review, please let me know.

Dave Denniston, Chartered Financial Analyst (CFA), is an author and authority for physicians providing a voice and an advocate for all of the financial issues that doctors deal with.

You can find his latest blog post by clicking here.

Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.

The views expressed are those of the author and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. In addition, the above list of articles and publications is not, and should not be constructed as, a recommendation, endorsement or sponsorship by United Planners Financial Services

*Past performance is no guarantee of future results

*All indices are unmanaged and are not illustrative of any particular investment. An investment cannot be made in any index. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The S&P 500®, a market-capitalization-weighted index of common stocks.

*Municipal bonds, Corporate bonds, U.S. Treasury Securities, Government Agency bonds, and CDs will fluctuate in value and if sold prior to maturity may be worth more or less than their original cost.

* Understanding inherent risks such as interest rate fluctuation, credit risk, and economic conditions are important when considering an investment in the financial markets.

*Be advised that investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

*In general, the bond market is volatile, bond prices rise when interest rates fall & vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

*Foreign investments involve special risks including greater economic, political, & currency fluctuation risks, which may be even greater in emerging markets.

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