It's basically the master plan
The third installment in our Portfolio series (you can see the first post on Geography here and the second on Risk here).
Today we are going to talk about Asset Allocation. Totally coincidentally, Ben Carson published a great post on this just a couple of days ago. Check it out, he's both more knowledgeable and a better writer than I am.
Asset allocation is basically what investments, and how much of each, you choose to buy.
The basic investment building blocks for many people are equities (shares/stocks), bonds, real estate (most conveniently in the form of REITs), commodities (commonly precious metals like gold and silver), and cash.
Figuring out your asset allocation depends on two things: what you want to do and how you think you might be able to achieve that.
Let's break it down into steps:
- Figure out how much you can invest (this is after you cover your living expenses and save up an emergency fund).
- Consider your timescale: how long are you going to invest for? If you are in your thirties, you could be investing for 60+ years. If you are in your late 50s, it's likely that you will need the money sooner.
- Think about your psychology. Are you likely to worry about your investments and feel bad if they fall in value? Or are you able to ignore temporary setbacks? If in doubt, go with a safer, more conservative portfolio.
- What do you need? If you already have enough money, it probably doesn't make sense to risk it to get more money that you don't need. On the other hand, if you are depending on your small nest egg, you probably shouldn't risk it either.
Now let's look at what different assets do in a portfolio:
- Equities provide growth over time. Very volatile (the price goes up and down in the short term), historically they have provided good returns. Individual companies tend to underperform, although the occasional standout may make up for this. The safest way to own equities is to buy index funds, products that include dozens to thousands of companies together. The further you are from living off your investments, the more equities you probably want.
- Bonds provide stability, and counterbalance equities. They are less volatile than equities but tend to grow less in the long-term. The closer you are to needing your money, the more bonds you probably want.
- Real estate provides income, and is different to bonds and equities so doesn't necessarily move at the same time as them. This will be a minor component in most portfolios.
- Commodities provide diversification, they are also different to bonds and equities, and often move in different directions. This will also be a minor component.
- Cash gives you 'dry powder' to take advantage of big price drops (it is good for investors when prices drop, like in stock market crashes).
So what might a portfolio look like? A very simple portfolio would be to have one equity index fund and one bond index fund. A popular rule of thumb is to have the percentage of bonds equal to your age.
So a 35-year old investor would have 65% equities, 35% bonds. Each time they made an investment, they would buy equities if they were less than 65%, or bonds if they were less than 35%. At the end of the year, if the allocation was considerably different from the target, they would sell the higher asset and buy the lower.
For example, if they had 73% equities and 27% bonds at the end of the year, they would sell 8% of equities and buy 8% of bonds.
A more complex portfolio might include all the asset types, and look something like this: 60% equities, 20% bonds, 10% REITs, 5% commodities, 5% cash. The owner would rebalance it as above and change it over time so that it includes more bonds.
My own portfolio is pretty much 100% equities. I am happy to suffer paper losses and am investing for the long-term. I also have a very high saving rate and am planning to live off interest/dividends in the future. This is not normal and should not be emulated.
One of the most famous portfolios is the permanent portfolio. I'm a huge fan of Harry Brown, particularly his book How I Found Freedom in an Unfree World, but he's most well-known for his investing ideas.
The book Global Asset Allocation (review here) goes into portfolios in huge detail.
Andrew Hallam writes about investing and portfolio design in a very clear and simple way in his book Millionaire Teacher (review of the second edition coming soon). If you are feeling a bit lost then buy and read Andrew's book.
Of course, within each asset class (particularly equities and bonds) you will have to choose which ones to buy. The post on Geography may help here.
So, was that helpful? Any questions? If people would be willing to post their own portfolios below, perhaps with a quick explanation of their circumstances (age, location, etc.) that would be really useful too.