Rosalind Evans
Follow our comprehensive manual to craft an ideal investment strategy tailored to your objectives, investment period, and risk threshold.
The secret to successful investing lies in forming a strategy and remaining committed to it. This is a universal truth agreed upon by investment experts, regardless of their market strategy.
The subject at hand is developing an asset allocation strategy that aptly distributes your capital among stocks, bonds, cash, and other assets. This distribution is dependent on your investment objectives, duration, and risk tolerance.
Diversification is a proven approach that spreads your investments across varied asset types to lower the likelihood of loss. The principle behind this strategy is that all assets do not behave identically.
However, this approach to asset allocation was put to the test in 2022 when stocks and bonds fell simultaneously. Market crashes such as this jeopardize the concept of diversification, precisely when investors rely on it the most, states Sebastien Page, Chief Investment Officer at T. Rowe Price and author of “Beyond Diversification: What Every Investor Needs to Know About Asset Allocation.”
Despite this, asset allocation remains vital. An old Wall Street adage proposes it contributes to 90% of portfolio returns. However, it impacts portfolio volatility more than returns. “The goal of asset allocation is to reduce the portfolio’s tendency to swing, similar to the function of a ship’s ballast,” Sam Stovall, Chief Investment Strategist at CFRA Research, explains. Crucially, this allows you to “keep your emotions in check, preventing them from becoming the greatest threat to your portfolio,” he adds.
Astute investors can interpret the 2022 market turbulence as an indication to make necessary adjustments to their portfolios, considering the changing market scenario. Bond yields are on the rise, and cash finally provides a decent interest rate. Despite recent dips, inflation continues to be high.
U.S. stocks are still pricey compared to other international markets despite having declined from their peak in late 2021 and recovered somewhat. Foreign stocks have recently been outperforming U.S. stocks.
To guide you in dividing your portfolio, we sought advice from the experts. We surveyed some of the top asset allocators to gather insights on portfolio construction. This process is a combination of art and science, and we will guide you through the steps professionals follow to assist their clients in building robust portfolios.
Understanding your investment objectives and risk tolerance is fundamental to asset allocation. It’s about “determining the optimal asset mix based on your risk tolerance and capacity, or investment horizon,” explains Robert Williams, Managing Director of Financial Planning at Charles Schwab. “Balancing these risks is fundamental to investment planning.”
Professional advisors start by gaining an overall understanding of your financial situation and settling essential questions.
Ryan Viktorin, a Certified Financial Planner at Fidelity Investments, asks, “What is the end goal?” Are you saving for retirement, your child’s college tuition, or a home down payment? “When is this supposed to happen? Is it five years away or 25?” Once you have established these parameters, you can begin formulating your investment strategy based on your goals, Viktorin suggests.
Your investment horizon is an essential factor in the level of risk you can accommodate in your portfolio, according to Page from T. Rowe Price. For instance, money for a home down payment due in three years should be invested in cash or short-term bonds, not stocks, to avoid potential losses.
Assessing your risk tolerance or your ability to handle volatility is a more challenging task. “Risk tolerance is a complex notion,” Page acknowledges. It’s tied to emotions, varies among individuals, and may be influenced by market conditions.
“During rising markets, individuals often express a desire for significant risk-taking, while they tend to avoid risk when markets fall,” states David Born, a certified financial planner based in Orinda, California. Major life circumstances can also impact this, such as undergoing a divorce, which typically leads to a lower risk tolerance, according to Blaine Thiederman, a certified financial planner in Arvada, Colorado.
Whether digital or high-net-worth, most financial managers aim to understand your investing personality – aggressive, conservative or somewhere in between. This includes gauging your probable reaction to a market downturn, such as a 20% portfolio drop in a single year.
An effective tool in risk assessment is an actual example from your investment history. Sabino Vargas, a senior financial adviser and certified financial planner at Vanguard, might ask about your actions during the 2022 market. If you sold, it suggests a more conservative stance. If you did nothing, it points to a moderate approach. If you purchased more, it indicates an aggressive strategy.
Certainly, simplifying this complex task is not straightforward and requires careful consideration. Identifying your risk tolerance is more art than science, says David Kressner, a managing adviser at Altfest Personal Wealth Management. However, it’s crucial in creating the right asset allocation strategy. The most successful portfolios are those you can maintain long-term, even during significant market fluctuations.
Kressner adds, “Incorrect decisions at the wrong time can drastically affect your results. You can avoid such mistakes by having the right allocation.”
The question is how much to allocate to stocks, bonds, and cash? Both your capacity for and tolerance of risk are key factors in this decision. It’s worth noting that most portfolios are labeled according to risk level – conservative, moderate, aggressive – but they also indicate investment duration. T. Rowe Price’s Page, for example, discusses ‘life-cycle-based’ portfolios in his book, referencing the years left until retirement.
According to Page, your most crucial decision will be your stock allocation, as it’s the most potent tool for calibrating your portfolio’s risk level. Use the model portfolios below as a general guideline for crafting a portfolio that suits your needs. Ideas for further detail are also included.
Stocks offer the most substantial long-term gains, but they are also highly volatile. Over the last two decades, they have returned an annualized 10.0%, despite enduring four bear markets. Each year, and sometimes more than once, the S&P 500 Index is likely to drop 5% to 10%.
Your stock portfolio can be diversified in numerous ways. For example, dividing assets between domestic and international shares is just the beginning. For both U.S. and foreign stocks, you can focus on company size (small, medium, or large) or lean toward a particular investment style (growth or value). You could also concentrate on specific sectors – tech, energy, materials, or industrial stocks.
Alternatively, you can simplify things by investing in index funds that cover the full range of stocks. For instance, a total stock market mutual fund or exchange-traded fund owns a stake in nearly every publicly traded stock in the U.S. We particularly recommend the Vanguard Total Stock Market ETF and its international stock counterpart, the Vanguard Total International Stock Index, or their mutual fund equivalents. The Fidelity Zero Total Market Index and the Fidelity Zero International Index are excellent broad index funds that do not charge annual fees.
Bonds, though offering lower returns, provide a buffer against stock volatility. Over the past 20 years, the Bloomberg U.S. Aggregate Bond Index returned an annualized 3.2%. In that period, it had only three years of negative returns.
Cash accounts now offer close to a 4% return. High Vanguard has a suite of target-date funds that we like a lot. The Vanguard Target Retirement series of funds have expense ratios of 0.13% to 0.15%, depending on the fund. Another noteworthy series of target-date funds is the Fidelity Freedom Index funds. These funds, unlike Fidelitys similarly named Freedom funds, track indexes and charge lower fees than their actively managed counterparts. Their expense ratios range from 0.12% for those close to retirement to 0.15% for younger savers.
Keep in mind, there’s no one-size-fits-all approach to investing. Each investor’s situation is unique, involving a complex interplay of factors such as age, risk tolerance, time horizon, financial goals, and personal circumstances. What’s vital is to develop a tailored investment strategy, stay disciplined, and remain focused on your long-term objectives, even amid market fluctuations. As you navigate the investing landscape, always remember to consult with a certified financial advisor if you’re unsure. Their expert insights can provide much-needed guidance and help ensure your investment strategy aligns with your financial aspirations.
