Asset Allocation

Recently I took a 3-week course on financial planning offered through UNLV. The most important topic covered was asset allocation. Asset allocation refers to how you allocate the money you have available to invest. What percentage of your money goes into your secure, moderate growth, and aggressive growth baskets?

You have many options for where to invest your money, and every option has a different risk/reward ratio. You can put all your money in the high risk/reward basket, such as aggressive growth stocks, and you may enjoy great gains, but you’ll also suffer huge losses when things go badly. On the other hand, you can put all your money in the low risk/reward basket and keep your assets secure, but then your gains will be very modest. If your gains are taxable, you need to make about 7% just to stay even, since you have to cover inflation + taxes (based on typical USA figures).

The point of intelligent asset allocation is to enjoy strong gains without taking on too much risk of losing your entire principal and having to start over from scratch. So you want to have some money in the aggressive growth bucket, so you have the potential to enjoy some big wins when things go well. But you also want to keep some money in your secure bucket, so you have backup funds to get back in the game if your aggressive investments go bust. Asset allocation involves determining how much to put in each bucket.

I’ve made mistakes on both sides. As a young adult, I kept all my money in a regular savings account, earning minimal interest while the market was soaring. Then in my late 20s, I put most of my money in stocks that lost 70-80% of their value during the dotcom bust, and it took me a while to rebuild those cash reserves. Both of these were good lessons for me.

A financial investment example

As an interesting illustration from the course, consider this hypothetical example. Suppose Erin and I are each going to invest $100,000 for 25 years, and we want to maximize our returns.

I decide to play it safe and stick the whole $100K in a fairly secure investment that yields 7% per year.

Erin decides to split her money into $20K chunks and invests in five different vehicles, which perform as follows:

  • $20K is lost completely
  • $20K returns 0%, so you only get the original $20K back
  • $20K is invested at 5%
  • $20K is invested at 10%
  • $20K is invested at 12%

Who gets the better total return? Let’s see how the numbers add up:

My 7% investment turns that $100K into $572,542 after 25 years.

Erin’s returns are as follows:

  • $20K lost = $0
  • $20K @ 0% = $20K
  • $20K @ 5% = $69,626
  • $20K @ 10% = $241,139
  • $20K @ 12% = $395,769

So Erin’s grand total is $726,534. That’s $153,992 more than what my 7% investment earned. It’s interesting that 40% of her initial investment returned zero or negative returns, and another 20% underperformed my 7% return. But those higher returns of 10% and 12% really pay off. Even though most of Erin’s picks were poor performers, being right just 40% of the time was all she needed.

By diversifying her investments, Erin was able to participate in the big winners while not being wiped out by the losers. Of course it would have been great if she could have invested the whole amount at 12% or more, but this example assumes she did her best to pick five potential winners.

To optimize your long-term investment gains, you need to optimize your asset allocation. Maybe you start with 1/3 of your money in safe investments like municipal bonds, another 1/3 in growth funds, and the last 1/3 in aggressive growth stocks. Over time these percentages will drift as each bucket grows at a different rate, so you need to rebalance them.

When your riskier investments lose money, rebalancing means transferring money out of your secure bucket to get back in the game and try again. And when your riskier investments pay off big, rebalancing means transferring money back to your secure bucket to lock in your gains. This strategy allows you to continue enjoying some big investment payoffs without taking on too much risk.

Beyond financial planning

After the financial planning course I realized that the strategy of asset allocation can be applied to other areas of life, such as work, relationships, and health.

Consider how you allocate your time. You can think of your time as consisting of several buckets, each having a different risk/reward ratio. If you have a full-time job that pays a flat salary, then most of your time is allocated to the security bucket, so you might want to shift some of that time to the entrepreneurial bucket to participate in the game for much greater gains. Maybe your job pays $20/hour, and you have the option of trying to make $50/hour doing consulting on the side, but your consulting efforts don’t always pay off. Some hours you make $50, but others you make $0. And as you slide the risk/reward ratio further, you may put yourself in the game for some of those delightful $10,000 hours.

You can also use non-monetary criteria for each bucket. With physical exercise you could have different buckets for allocating your time to aerobic conditioning, endurance training, strength training, stretching, sports, and fitness education. Each of these buckets will have a particular impact on your physical health. You would then allocate a certain percentage of your available exercise time to each of these buckets in accordance with your fitness goals. I remember when I started exercising regularly, all I did was running (aerobics). Then I got into distance running (endurance). Today I do about 40% aerobics, 45% strength training, and 15% disc golf (sports). I had the most balanced allocation when I trained in Tae Kwon Do, which was a great blend of everything.

It’s up to you to decide what particular allocation works best for you, whether you’re trying to get better returns on your money, your time, your energy, your goals, or something else. Working like a monomaniac on any one thing for too long will unbalance you, as will neglecting a key area for too long. Intelligent asset allocation can help you consciously determine the right mix that keeps you in the sweet spot of balancing risk vs. reward, work vs. leisure, strength vs. flexibility, solo time vs. social time, and so on.