Asset Allocation: Easy as Pie a la Mode

Today, we’ll discuss the concept of asset allocation – which is just a fancy way of saying how you’ll split your money up into different buckets.  In most financial literature, you’ll see it displayed as a pie chart.  This pie will either be made of just 1 thing or they will be split into different sized slices.

I hear a lot of internet advice to investors is to just buy a total stock market index fund and be done with it.  While this approach works for some, others feel uncomfortable with it. This article will dive into why we want different slices and what should these slices be.

Generally, investing falls into 4 broad categories and within these categories, it can be further classified from there.

Defining Asset Categories aka Pie Flavors

Apple Pie: Cash

This is pretty self-explanatory. Everyone is familiar with apple pie as they are with cash. This is your savings accounts, your emergency fund, and the like.

Pumpkin Pie: Bonds

Also common, pumpkin pies are easy to swallow. This is a situation where YOU are the lender to someone else.  They need the cash to do something like start a new business or launch a product and you lend it to them for a set amount of interest. I go into more detail here.

Peach Pie: Equity

Peach pies are a bit more fickle.  Some years you get spectacular stone fruits and the pies are amazing.  Other years, they are “meh”.  Stocks are very similar.  Stock is ownership.  In this case,  Equity is investing in a company by becoming a part-owner.  By investing in equity, you share in the gains and losses of the company. And as with peaches, some years the company will do very well leading to good results.  Other years, the weather will not be good and the pie is mediocre. Like with Bonds, I go into more detail here.

Stargazer Pie: “Alternatives”

A while ago, I learned that the English will put fish in their savoury pies with the fish heads poking out to “stargaze”.  Huh.  That might appeal to some, but I can imagine it’s not for everyone.  I find that’s like Alternative assets. Unimaginatively, this just means any investments other than the 3 above.  What can I say, Financial people aren’t known for their creativity.  In this bucket, we lump in real estate (yes, your house) which is the most common alts for common folks like you and me.  Fancy schmancy investors might get into things like Private Equity or Private Debt, Commodities or derivatives.

Diversifying Diversifiers: Apple vs Pumpkin Pie Showdown

If you ask most personal finance bloggers why you’d have anything other than stocks, they will probably answer you with “Diversification”.  But what exactly does diversification mean?

Most people would describe this as “not putting all your eggs in one basket”.  In the case of asset classes, you are spreading risk around how you make returns.  Bonds make money with interest paid to you.  Equity makes money when the company makes more profits and they distribute some of it to investors in the form of dividends.  Alternatives, well, it depends.  That’s another article later.

When you diversify across asset classes, ie across bonds and stocks, you are saying that I want to be paid in interest payments and in company gains.  But I will split it my way.  Let’s pretend all my investments generate, say, $1000/year.  Maybe I want $300 to come from interest payments.  This way, every year, I know I’m getting $300 and that’s a fixed amount.  Then I want $600 to come from dividends/gains from stocks.  This amount is $600 this year, but maybe next year, it’ll be $500 or $800.  It’s variable, but I don’t need to know how much I’m getting because the $300 is what I needed to be sure about.

Finally, I might have $100 that is from alternatives.  While housing does usually go up, we saw in 2007-2008 that this assumption is not fool-proof.  Sometimes it doesn’t.  And we need to have enough from other sources to make up for the times it goes down.

In this case, think of having different flavored slices in your pie. Sometimes you will want apple pie, but other times, you’ll want something more seasonal like pumpkin.

Correlation

Most of the time, these asset classes returns are not tied to each other.  Bond returns don’t generally depend on stock returns.  That’s because bond interest payments will always come first before a company pays any dividends. As for stock returns, once the bond payments are taken care of, the company might have a knock out year.  The bondholders don’t have a claim to any of that extra money. Their contract said that they will just get their interest payment.

The idea that these asset’s returns don’t depend on each other and therefore don’t move together.  There are other reasons that asset returns don’t track with each other beyond company business.  Investors also influence the price of these assets.

If we are in a phase of strong economic growth, more people feel comfortable with stocks.  Since the economy is so good, these stock prices go up and up.  If someone is holding bonds and they want to own stocks, they have to first sell their bonds.  But in this market, who’s going to buy it?  They must offer a discounted price to entice someone.  In this case, bond prices go down and stock prices go up through supply and demand.

This is an example of negatively correlated assets.

Others are positively correlated, meaning that if the price of one goes down, the likelihood of another price going down is high.  An example would be if prices of Coca Cola stock is going down, chances are, prices on Pepsi stock is probably going down too because their businesses are very similar.

Then there are non-correlated assets.  This means that one asset class behaves independently of another. Commercial real estate (office leases) probably isn’t related to wireless subscriptions on a carrier, so the alternative asset (office leases) is not correlated to the price of Verizon stock.

Why Does Asset Allocation Matter?

There are a lot of different factors that help the return of a portfolio.  The ones we hear about most is called Security Selection.  This is when you pick that stellar stock.  When you buy Amazon back in 2001 or buy Apple in the ’90s.

Another factor is trading.  We hear that most everyday investors lose their money by trading a lot.  They are chasing that next Amazon or Netflix.  They have insatiable FOMO.  Every time something is bought and sold, there are commissions or other transaction costs.  That also eats into a portfolio’s return.

But what most people don’t talk about is asset allocation.  That’s too bad because this is actually the most important factor.  This alone determines over 90% of what the portfolio return is likely to be, regardless of trading and buying these unicorns.

When you think about it, it makes sense.  If 90% of your money is sitting in savings accounts earning 2%, you can see how hard it would be to have a total return of 7% on the whole pot of your money.  The other 10% of your money would have to be earning 50-60%.  Whereas if 90% of your money is invested in the stock market and over the long term (20 years), stocks generally average 8-9%, then getting 7% is now much more likely.

Rules of Thumb Guidelines

In the Personal Finance FIRE community, there is a lot of referencing JL Collin’s Stock Series where he basically recommends to just buy 1 US all market stock index fund (VTSAX) and nothing else.

There’s nothing inherently wrong with that advice.  I just don’t feel it’s not the whole story.  There are other options that could be more appropriate depending on your comfort level.  To be 100% in stocks means you have to be comfortable with all the ups and all the downs.  Since 2009, we have been in an 11-year cycle of stocks going up more than they have gone down.  Also, most down days in the stock market can be -1-2% a day.

On the other hand, Bonds have also trended up during the last 11 years, albeit much slower.  However, their worse year in the last 11 years was -1% A YEAR.  Compared to -1% a day, bonds are a lot more steady.  That might be of comfort to you.

So how much bonds to add?

Efficient Frontier in Asset Allocation

Modern Portfolio Theory proposes that you take only the amount of risk you are comfortable, but you optimize the returns you could get for that amount of risk. This is based upon a plot of each portfolio’s risk against their expected returns. This is what’s known as an “efficient frontier”.   It’s generally an upward sloping curve meaning the more risk you are willing to take, the higher the expected return.  The final consideration is that there are investments that fall under that sloping curve.  Those are investments where you are taking on a certain level of risk, but will unlikely to earn a return compared to a better investment.

This is best illustrated by an example.  Based upon historical return and risk, Gold as an investment has similar amounts of risk as the Canadian Stock market (all of the public stocks in Canada).  However, when Gold is plotted according to the rules of MPT, it lies below the curve.  The Canadian Stock market lies on the curve.  So in this case, according to this theory, investing in Canadian Stocks is “Optimal” and Gold is not.

100-Age Rule to Asset Allocation

This rule sounds exactly like what it is.  The amount of Stocks to own according to this rule is to subtract your age from 100.  So if you are 30, then 70% of your portfolio should be in Stocks.  The other 30% in Bonds.  With rules of thumb, it’s generalized.  Some critique of this approach is that it is actually too conservative and that it wastes the first 10 years of your retirement when you likely don’t need to draw heavily from your retirement portfolio.  A modified rule of thumb is now 110 – Age.

60/40 Rule of Asset Allocation

Again, another straight forward rule.  This strategy recommends keeping 60% of your money in Stocks and the other 40% in Bonds.  That’s it.  Rebalance when it gets out of whack, but otherwise, don’t worry about it.

Ok, but How Do I Choose?

If you were to ask me, I’d say don’t overthink it too much.  The 100% Stocks and the 60/40 rule are both very straight forward and easy to do yourself.  One is very aggressive and the other considered Averaged Balanced. If you want easy, then choose between one of these 2 options depending on how much risk you can take.

If you want to be a little bit more hands-on and want to tailor the amount of risk you want to take, then the 100-Age or Modern Portfolio Theory is for you.

Why do I say don’t overthink it?  Because there is no right or wrong and you can change your approach if you find the one you choose doesn’t quite fit your circumstances.  This is a decision that is not etched in stone.

Also, I found it fascinating to learn that Harry Markowitz, the father of the Modern Portfolio Theory, for which he won a Nobel prize, invested in a 50/50 portfolio of stocks and bonds.  When asked why he didn’t use a more aggressive strategy, he answered that his risk tolerance was too low and he wanted to play it safe!

If you want to learn more about asset allocation and the role it plays in portfolio construction so you can build your own, sign up here to be notified when my Investing Made Simple course goes live!