Asset allocation is the rigorous implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame.
Whoa, Whoa, Whoa! Hold it right there.
I just promised you a super simple explanation for asset allocation and then I start off with something that may read like complete gibberish to you.
So before you hit the back button, allow me to explain why I did that.
The concepts of personal finance are really simple. But for some reasons unknown, we are given that information in a way that makes personal finance come across as a really technical, complex and dull subject!
The above definition of asset allocation is just that. It is technically true but comes across as confusing, is definitely not simple and is boring as hell.
No wonder most people give up on learning the concepts of personal finance when faced with dreadful language like this.
So let me assure you of one thing. Just like my financial wellness guide to improve your financial life, everything you read in the rest of this article will be in a language that makes sense to you.
(By the way that complex definition of asset allocation above is from Wikipedia)
Let’s get started.
What Are Assets
As we have seen earlier the simple rule to get rich, consists of 3 steps:
First Step – Save Some Money
Second Step – Invest That Money
Third Step – Watch that Investment Grow.
Asset allocation is something that you encounter in the second and third steps outlined above.
Here is how it works:
Investing the money you have saved in step 1 is one of the most important steps of personal finance.
Investing your money means putting your money in things that will make it grow a few years down the road.
“Things” you put your money into to make it grow are called assets. You might have already heard about most of them (even if you didn’t know they are called assets).
These “things” or “assets” include fixed deposits in a bank, shares of companies on the stock market, mutual funds, a house, a piece of land, fine wines, gold, silver – You get the idea !
All of these assets have something in common – They have the ability to grow your savings into a much larger amount in the future if you buy them today.
Asset allocation is the act of choosing how you should distribute your money between all these asset choices that you have.
They all have the potential to make your money grow but they don’t work and act in the same way.
So before we delve into how we make the choices, it is useful to understand how all these assets differ from each other.
All assets fall into two broad categories – Assets that let you eat well and assets that let you sleep well.
Assets That Let You Eat Well
Eat Well Assets – Shares in companies on the stock market, investment funds that hold shares, property in specific locations etc.
These eat well assets have the potential to grow your savings into a much larger amount in a few years.
They are your best chance to reach the financial goals you have set for yourself.
But here is their flip side – These eat well assets are volatile. They don’t work in a predictable manner from day to day basis.
They may double your money in a few months and then drop it by half in the following few months. And then swing back again up without any warning.
They will help you grow your money over the next 10-20 years, but the journey will be nerve-racking.
It is like putting your savings on a roller coaster. It will be a lot of fun but there is no calm and quiet during the ride.
And there will definitely be no sleeping peacefully with these assets in your personal finance life.
Assets That Let You Sleep Well
Sleep Well Assets – Bank Deposits, Government backed schemes, investment funds that hold very safe bonds, gold etc.
These sleep well assets are unlikely to grow your savings into a much larger amount in a few years. They will rise at a much slower pace compared to eat well assets.
By themselves, they may not be able to help you reach the financial goals you have set for yourself.
But here is their bright side – These sleep well assets are predictable.
You will know today itself, how much money you are likely to have 5-10 years from now if you choose these investments.
The chance of anything going wrong with these sleep well assets is extremely low compared to their more volatile counterparts – The Eat Well Assets.
They will let you sleep soundly for the next many years without worrying about them every single day.
No roller coasters here – It is a smooth ride with sleep well assets.
The Role of Asset Allocation
So now that you know about the Eat Well Assets and the Sleep Well Assets which one would you pick?
If you are like most people then your answer will be – “They both have some positive traits. Is there any way that I can get the benefit of both types of these assets?”
That is a good question and that is exactly what asset allocation is all about. It is the process of choosing a mix of these Eat Well and Sleep Well assets that are just right for you.
Your asset allocation will be unique to you – It depends on your personality and your financial goals.
We are all unique. Some of us can live with a higher amount of volatility without much trouble as long as they can get a higher return on their investments.
For others this huge day to day volatility is not worth losing sleep over.
They would rather end up with less money than have a heart attack looking at their savings swing up and down like a bungee jumper.
The Importance of Asset Allocation
Given a choice we would only pick the positive aspects of both these asset types and reject the negative qualities.
However, these assets come as a combo package – The potential of higher returns comes with higher risk (volatility). If you reduce the risk, the growth possibilities for your money also go down.
The importance of asset allocation is therefore about finding a balance.
A balance between the risk you need to take to reach your financial goals and the risk you can tolerate as an individual.
There is no point being able to reach your financial goals if the journey will leave you a nervous wreck.
On the flip side you also don’t want to miss reaching your financial goals just because you were too afraid to take any risks at all. Not taking any risk is also a risk.
The Rule of Thumb for Asset Allocation
Take your current age and subtract it from 100. What you get as the answer should be the amount to put in Eat Well Assets. The remaining should be in Sleep Well Assets.
So if you are 40 years old then 60% (100-40) of your money should be in eat well assets. The balance 40% should be in sleep well assets.
When you are younger – Eating well is more important. Sleep can wait.
But as you get older – Sleeping well gets more important.
Asset allocation simply follows how we operate in real life.
Your financial advisor will be able to come up with your ideal asset allocation based on your financial goals and risk taking preferences.
Alternatively you can use a number of good online asset allocation calculators like this one from Vanguard.
The right asset allocation for any individual is not a perfect science. It is more of a combination of art and science.
I hope by now you have a much better understanding of what asset allocation is all about. So now let’s see if we can craft a simple definition of asset allocation.
The Simple Definition of Asset Allocation
The right asset allocation is one of the main factors that will decide if you can achieve the financial goals that are part of your personal financial plan.
We need a good combination and eating well and sleeping well to fully enjoy what our lives have to offer.
The same goes for your money and your financial goals.
Choosing the right combination of assets will ensure that you enjoy not just the destination but also your financial wellness journey to reach that destination.
That is the beauty of asset allocation.