Asset allocation is the most important decision you will make when it comes to investing. So why do so many investors get it so wrong?
Chances are, if you’re like many investors, you’re probably getting your asset allocation wrong. Asset allocation is the most important decision you will make when it comes to investing, in addition to the decision to just get started. Many studies have shown that a large percentage of investors’ returns come down to getting asset allocation right.1
So where do many investors go so wrong?
Why Is Asset Allocation So Important?
Essentially, asset allocation is the decision surrounding what percentage of your investments should be in equities vs. fixed income vs. cash. This has everything to do with your specific investing goals, even if you have many at once. If you don’t get your asset allocation right—let’s say your portfolio should’ve been 80% equities but it’s really 40% equities—it’s not going to matter how great your underlying investments are if the market is up and you’re missing out on major economic growth. The flip side is also true. If your goals and time horizon indicate you should be invested 80% in equities and you are, it may not matter as much if that 80% sits in a mediocre mutual fund, as even a mediocre mutual fund is likely to perform well if its asset class is doing well.
I started in this business in 1997 or 1998, during the technology boom. Despite sitting with certain clients and showing them the risks they were taking—many had too much concentration in technology stocks—some of them went against our advice. When the bottom fell out of technology, it ruined their retirement because they were over-concentrated, not as diversified as they should’ve been, and had no way to recover if they were too close to retirement. In fact, some were already retired and using the tech boom as a way to enhance their retirement spending, rather than simply viewing the strong returns as icing on the cake. This pursuit of grand slams destroyed their retirement. Some had to downsize their residences as a consequence. It was very real.
The flip side is also true. Let’s say you’re a young investor who’s risk averse, so you invest heavily in fixed income and cash; you may not see as much volatility, but over the long term your portfolio will likely grow less because you’re not exposing yourself to the risk of the markets. You should think not about the returns of any given market or index, because it’s not really relevant to you. What actually matters are your priorities and how much you need to achieve them.
Too Many Investors Make This Big Asset Allocation Mistake
Asset allocation entails setting aside certain percentages of your portfolio for different types of investments. So why do too many investors inadvertently fill their portfolios with investments that are all more similar than they should be?
It’s easy to make this mistake because of the human tendency to look for investments with the best performance. When the market is doing well, the high tide lifts most if not all boats. So in a good market, if you’re assessing a number of different mutual funds and trying to decide where to put your money, many of the funds may appear pretty similar when it comes to performance. Of course, the problem occurs when markets no longer perform well. If you’ve inadvertently chosen a selection of funds that are too similar to each other, they may all go down at same time, eliminating the benefit of diversification.
Seek Different Solutions When Building a Portfolio
Instead of searching for the best-performing funds, it’s crucial to search for investments that represent different sectors of the economy. In a diverse portfolio, some investments will perform better while others may even lose money. The whole point is that each plays a different role. Think of a football team: Not being diversified is like having nothing but wide receivers on the field. If you had a team of nothing but wide receivers, there’d be no one to throw or run the ball. It’s not a well-balanced team or a winning formula. Similarly, if you concentrate your investments in just a couple areas or styles, you might open yourself up to increased risk if that one area declines.
Broadly speaking, make sure your investments expose you not only to broad asset classes but also to other types of diversification. So, within the broad class of “equities,” you can opt for a mix of large-cap growth, large-cap value, mid-cap, small-cap, domestic, international and so on. Within the bucket of “fixed income,” there’s government bonds, corporate bonds, mortgage-backed securities.
At the end of the day, it’s important to make sure you have the right exposure to the areas that make sense for your expectations and time horizon.