What Most Get Wrong About Two of the Most Common Concepts in Investing

The concept of asset allocation was one of the first concepts I studied on my road to fiscal fitness. Asset allocation is the practice of dividing an investment portfolio among different asset categories. This concept can support another well know investing concept, diversification, spreading your money among various investments in the hope that if one investment loses money, the other investments will make up for those losses. People often get these two concepts mixed up or believe they mean the same thing. Many investors use asset allocation as a way to diversify their investments between the asset categories. However, some investors purposely choose an investment allocation that is not diversified.

Asset Allocation and Diversification

A young investor might go 100% in stocks, 0% in cash and 0% in bonds. This allocation could be viewed as a proper asset allocation because they are willing to assume a high level of risk and have a long time to reach their goal. Therefore, choosing an asset allocation model does not necessarily diversify a portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments. To be well diversified, investments should be spread between and within the different asset categories.

The most common asset categories are cash, bonds, and stocks. Cash and cash equivalents (e.g. savings deposits, certificates of deposit [CD], treasury bills, money market funds, and money market accounts) are the safest investments as the federal government guarantees many of the investments in this category. However, they generally offer the lowest return of the three major asset categories and a concern for SavvyInvestors is that inflation will outpace the rate of return and erode the cash asset value over time.

Eggs in a Basket - Prisma Cosmopolitan

In the middle of the spectrum you have bonds. They generally offer better returns than cash and cash equivalents, yet lower returns than stocks. For many investors, holding bonds is an attractive alternative to leaving the investment portfolio at greater risk if too heavily weighted toward stocks. Investopedia provides a good basic tutorial on the different types of bonds.

On the other end of the spectrum from cash is stocks. Stocks, also referred to as equities, represent a share of a company held by an individual or a group. This asset category has historically had the greatest volatility, greatest risk, and highest returns among the three major asset categories. Their appeal is that they offer investors the greatest potential for growth. Mutual funds, made up of a collection of stocks, bonds, and other securities would also be grouped into this asset category.

Why Choose Stocks When Saving for Retirement? [Fidelity Viewpoints]

SavvyInvestors understand that the reward for taking on more risk is that there is a potential for a greater return on investments. Generally speaking, the longer the time horizon, the more likely investors will make more money by thoughtfully investing in asset categories (e.g. stocks and bonds) with greater risk, vice limiting investments to assets with less risk – and less return – like cash and cash equivalents.

Final Thoughts

Remember, to be well diversified, investments should be spread between and within the different asset categories. The mix of cash, bonds, and  stocks that you hold in your portfolio at any given time is very personal and will change over time. The allocation of your assets is not a case of doing it once and being done; it is not a static practice.

A common practice among investors is to increase their cash and bond holdings, relative to their stock holdings (providing greater protection to their nest-egg), as they approach their investment goal, retirement in many cases, and prepare to start the withdrawal process.

Ultimately however, the asset allocation that works best for you at any given point in your life will depend largely on numerous factors such as your tolerance for volatility and risk, your time horizon, and your goals.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

8 Comments

  1. Hey, James. Another thoughtful post on a key component of personal finance. Are you familiar with the Phau-Kitces model of asset allocation when entering retirement? They advocate going into retirement with a stock/bond mix of 30/70 or 40/60. This way you account for your biggest threat–the sequence of return threat. No one wants to retire the year of a major stock market correction (e.g., 2008). Mrs. Groovy and I currently have 50/50 mix between stocks and bonds/cash. I would like to go to 40/60 by the end of the year. But Mrs. Groovy is happy with 50/50. So we’ll see. If the admiral wants to stay at 50/50, we’ll stay at 50/50. It sucks being a lowly ensign on this groovy ship.

    P.S. I’m currently reading a book called Evicted. It’s about the poor of Milwaukee and their housing struggles. And it makes some passing references to the cream bricks of the historical architecture. So when’s the next installment of the Cream City Hustle, my friend?

    • Although I’m not intimately familiar with the Phau-Kitces model, I do have some familiarity. Whichever model an individual follows, I believe the key is to understand the hazards and put a detailed plan – which will differ for everyone and their unique circumstances – in place that addresses those hazards and ensures the retirement money lasts at least 35 years.

      With respect to Cream City Hustle, unfortunately, I didn’t really get enough feedback/comments – which I translated to interest – on the installments to justify the effort.

      • Hey, James. Thanks for the feedback. What makes the Phau-Kitces approach appealing to me is that it gives you plenty of bonds and cash (i.e., ammo) to pour into stocks should a big correction occur in the first year or so of your retirement. And I hear you about Cream City Hustle. I’ve been meaning to buy it for a while now. Great read. So it’s about time I paid the author for his contribution to my intellectual growth. Talk to you soon, my friend. Cheers.

        • “What makes the Phau-Kitces approach appealing to me is that it gives you plenty of bonds and cash (i.e., ammo) to pour into stocks should a big correction occur in the first year or so of your retirement.” That was the element I do remember in the little bit I have read on the method/model.

          Thanks for stopping by and sharing, my friend.

  2. So very true James. Successful asset allocation and diversification is another one of the fundamentals of creating a robust FIRE portfolio. Usually not achievable until you are some way down the path to financial independence as this needs to be developed as you grow your fund and learn how to make educated choices on where to place your money for the return that fits your preferred risk.

    It is also suggested that you alter your risk profile as you get closer to FIRE to ensure that you lock in profits and create a safer portfolio as your potential to earn reduces. In other words, as you get older, your portfolio should become less risky. The rule of thumb, I have read, is that your portfolio risk should reflect your age as a percentage; i.e. at 30 years old, you have 30% low risk and 70% higher risk. At 50, you’re looking at an even split. At 70, only 30% should be in the higher risk category and 70% low risk.

    At the end of the day though, everyone has their own risk profile and should invest in a way that they are comfortable with.

    • Thanks for stopping by and sharing your thoughts, my friend. With respect to altering your risk profile as you get closer to retirement, the approach you describe is a great rule of thumb for most. My approach is going to be a little different as the wife and I are fortunate in that we will have secured three defined benefit plans (pensions) and will be able to live our chosen lifestyle on the income they will provide. Therefore, the money in our retirement/investment accounts is ‘gravy’ in a way; and I will likely be more aggressive than the rule of thumb you mention. As opposed to being at a 40/60 split at age 60 – when we plan to retire – I may be at a 65/35 split.

      Another consideration is something I’ve read recently in a few different places, the Monte Carlo analysis. The basic idea is that it’s possible that people are being too conservative as they approach retirement. Check out What’s Your Longevity Assumption – Are Planners Being Too Conservative?

      Again, thanks for stopping by, my friend.

      • I completely agree with you James. My personal risk profile is a little different to the rule of thumb I described. I have gone for a property-heavy portfolio with the rest in index funds and some in P2P lending. This probably equates to a 60/35/5 split with real estate being pretty safe.

        As I said, it’s all about what an individual is comfortable with and you are fortunate to be in a position where you can select some higher risk on part of your portfolio but still remain financially safe long term.

        I haven’t heard of the Monte Carlo analysis. I’ll go and take a look at that. Thanks for the link.

        • “As I said, it’s all about what an individual is comfortable with.” Absolutely. Additionally, an individual’s level of financial literacy and willingness to actively work their plan are key factors. If someone is content to maintain just basic knowledge and has a very basic portfolio, they will certainly be better served by sticking to a plan that follows generic guidelines that have proven effective for most people. Conversely, those that possess higher levels of financial literacy and are comfortable with managing their own portfolio – and have a better understanding of the underlying factors/logic of some of the investing guidelines (e.g. the 4% rule) – may benefit by tailoring a plan that fits their specific situation.

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