If you ask one hundred people what the most important factor is in determining the long-term return on your portfolio, my guess is that 90% will give you the wrong answer.
They will talk about picking great stocks, avoiding the big market downturns, beating inflation, owning gold, finding great managers, etc. Wrong, wrong and WRONG.
Asset allocation has proven in numerous studies to be the number one factor in determining your portfolio return. Ever heard of it? Perhaps not, as it is not as exciting nor sexy as trying to time the market or picking the next great company. However, if you really want to be a great, or even an above-average investor, you must start with your asset allocation.
Rather than focusing on things you cannot control (like the return on the market), shift your focus onto the things you can control. Loosely defined, asset allocation is your split between stocks and bonds, and understanding and controlling it is extraordinarily important.
In a portfolio, stocks represent risk. Risk and return are closely linked: the higher the risk, the higher the return. Bonds represent safety: you lend money and get it back with interest. These are simple definitions, but adequate.
The amount of risk you are willing to take is a reflection of your investment time horizon (how long until you are dead!), and your risk tolerance.
So what can help you determine your asset allocation? One useful approach is to look at target date funds. These are funds provided by major mutual fund companies that make the asset allocation decision for you based upon your age. Look closely at several of these funds, because they can vary dramatically. This approach can give you a starting point for your own asset allocation, or you can simply accept their asset allocation decisions and invest directly in a target date fund.
Another good approach is to work with a financial advisor. Along with many other aspects to managing your money and planning your future, determining your asset allocation is a priority.
However, be aware of any solution that turns asset allocation into a mathematical formula. For example, my elderly stepmother is living off her portfolio. Nearing eighty years of age, you would expect she would have minimal exposure to stocks and mostly own bonds. But you would be wrong. Her portfolio is 70% stocks and 30% bonds. Why? Well, her portfolio is large relative to her spending needs, meaning she has the resources to ride out a lengthy bear market. Therefore, her asset allocation can be more aggressive, and also reflects the age and time horizon of her heirs rather than herself. This helps illustrate why asset allocation should not be determined by a clear-cut formula.
Use your asset allocation as a shield to avoiding the fear, greed and panic that can drive the market. For example, in the great market meltdown of 2008/09, the popular press quoted many serious people exhorting you to sell (“Get out of the market now!”) to protect what was left. However, if you followed your asset allocation, and rebalanced your portfolio once a year in January, you would have bought stocks when they were cheap and sold bonds when they were expensive – exactly what most investors do not do. Your portfolio would have grown handsomely as a result!
At the end of the day, your asset allocation must be a “can I sleep at night?” decision. At some point, any portfolio will lose money, and you must be OK when losses occur in yours, and understand it is expected based on your asset allocation.