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Investment Strategies that Work – Day 4 – Asset Allocation Strategies

by Neal Frankle, CFP ®, The article represents the author's opinion. This post may contain affiliate links. Please read our disclosure for more info.

asset allocation stratgiesWhat the heck are asset allocation strategies?

Let’s recap what we’ve covered already. We started by discussing investment strategies in general. Then, we looked at market timing. And yesterday, we covered buy and hold.

Think of asset allocation as an investment stew made up of buy and hold with a pinch of market timing. A typical asset allocator buys a variety of mutual funds. Then, periodically, she sells some funds and buys others in order to keep the overall balance in place. I’ll explain.

The concept of asset allocation is really nothing more than keeping your eggs in more than one basket. This way, if one type of investment does poorly, another will (hopefully) do better. In theory, it reduces the risk of investment losses.

Since equity funds have been historically more volatile than bond funds, you first decide how much risk you are willing to take. If you want a higher return and are willing to take more risk, you use an allocation that is more heavily weighted towards equity funds. If you are risk-averse, you weight your portfolio toward bonds and lighten up the stock funds.

Asset allocators use all kinds of funds. The investments span from equity to bond funds, from large to small company funds and from domestic to international and global.

Even though you probably have better things to do with your time, if you are an asset allocator and wondering what to do with savings, you have to rebalance your portfolio – at least once each year.

I’ll explain why by way of example.

Let’s say you start with $100,000 and you decide to put 50% in bonds and 50% in stocks. At the end of the first year your portfolio is worth only $80,000. The stocks are worth $35,000 and your bonds are worth $45,000. You no longer have the 50-50 split you wanted…do you? Nope. So you must sell off $5,000 in bond funds and buy $5,000 in stock funds. This will give you $40,000 in each and a beautiful 50-50 split.

You might be asking yourself why on earth you’d buy more equity funds when they lost more money than bonds. Have those asset allocators gone crazy?

No, they haven’t gone crazy. The reason you sell off the higher-performing asset (or at least the one that has done the least damage) to buy more of the lower-performing asset is to reduce risk. The theory is that no asset class (bonds or stocks) does well forever. By moving money into the lower-performers, you’ll be taking advantage of lower prices and, hopefully, those lower-performers will start doing better soon. That’s the theory and many people rely on this method to help provide greater security when it comes to withdrawal strategies.

How has it worked out? It depends what timeframe you consider. Here’s how different asset allocation models performed according to Wikipedia:

Cumulative return after inflation from 2000-to-2002 bear market

80% stock / 20% bond -34.35%
70% stock / 30% bond -25.81%
60% stock / 40% bond -19.99%
50% stock / 50% bond -13.87%
40% stock / 60% bond -7.46%
30% stock / 70% bond -0.74%
20% stock / 80% bond +6.29%

So in the bear market of 2000-2002, a very conservative investor earned 6.29% while the aggressive investor lost 34.35%. So far so good.

But remember, we can’t have our cake and eat it too. Here’s what Wikipedia said about expected returns from various asset allocation models going forward:

Projected 10-year cumulative return after inflation
(stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly

80% stock / 20% bond 52%
70% stock / 30% bond 47%
60% stock / 40% bond 42%
50% stock / 50% bond 38%
40% stock / 60% bond 33%
30% stock / 70% bond 29%
20% stock / 80% bond 24%

So you could have avoided large losses by having a risk-averse allocation in the bear market of 2000-2002. But your expected returns going forward would have been lower. Nothing wrong with that. It’s simply a trade-off between risk and return. If you are an asset allocator, you make the decision based on your financial needs and risk tolerance and you (are supposed to) stick to that decision.

But let’s consider how asset allocation funds did last year:

assedt-allocation-perfr_page_1

Not so well. Asset allocation could have helped you curtail some of your losses in 2008, but it wouldn’t have saved from having some pretty deep wounds to lick. The “best” fund still cost investors north of 25% of their money. Ouch!

So once again, we see an investment approach that has some historical support but still doesn’t deliver the goods 100% of the time.

Are you seeing a pattern yet? We’ve seen that in market timing, buy and hold, and now here with asset allocation. All these strategies are structured to provide certain benefits at certain costs. There really is no free lunch. Invest knowing what these costs are and understand that even with the best plan, things can and do go wrong.

Having gone through this, I must say that for the right investor, asset allocation is great. It is a rigid system that keeps your emotions out of the equation. Also, since the assets are diversified, it should help reduce painful losses.

Tomorrow we’ll wrap up and discuss which approach might be best for you. But let me ask you this: from what you’ve seen so far, which model fits you best? Why?

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Comments

  1. Brownson says

    August 22, 2009 at 9:17 PM

    I Don?t Usually Reply to Posts But I Will in this Case! Awesome, What a Great Site and Informative Post, I Always Wanted to Write in My Site Something Like That. Thank You!

    Reply
  2. SJ says

    April 23, 2009 at 8:01 AM

    I think I’ll try/trying a combo of asset allocation and market timing. Maybe. Right now there’s not much money I have invested so yea….

    I think the best part is the “No free lunch” part. Free lunches end after college =) ; but yea, it’s so true. Even in technical design there are always tradeoffs. Pretty funny.

    Reply
  3. Neal says

    April 23, 2009 at 3:51 AM

    Thanks…..but never be embarrassed. I am truly inspired by the path you are on. We are learning together.

    You’re a kind, honest, brave soul and the blogging world is better w/you in it!

    Reply
  4. Baker @ ManVsDebt says

    April 23, 2009 at 3:41 AM

    Neal,

    Your articles this week are really awesome!

    Everytime I read one I am both (a) embarrassed that I don’t know more and (b) wishing I was actually in the market!

    Keep up the great work!

    Reply

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Who is Neal Frankle

Neal Frankle

I'm a CERTIFIED FINANCIAL PLANNER™ Professional with more than 25 years of experience. I feel very blessed and hope to share my personal financial experience and professional wisdom with readers of WealthPilgrim.
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Retirement financial education for people age 55+ seeking to retire well and for those retired seeking to enjoy a better retirement.  We discuss retirement planning, retirement investments, taxes in retirement, retirement spending, IRA and 401k distributions and we will personally answer questions that you pose in the video comments.

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Neal Frankle is a retired registered investment adviser. Larry Klein is a retired financial advisor and retired CPA. They have 70 years of financial advising experience to share so that you have your best retirement years.

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Retirement financial education for people age 55+ seeking to retire well and for those retired seeking to enjoy a better retirement.  We discuss retirement planning, retirement investments, taxes in retirement, retirement spending, IRA and 401k distributions and we will personally answer questions that you pose in the video comments.

While so much financial information is about preparing for retirement, what about managing your finances in your retirement years? That's exactly what we cover at Retirement Crusaders.

Neal Frankle is a retired registered investment adviser. Larry Klein is a retired financial advisor and retired CPA. They have 70 years of financial advising experience to share so that you have your best retirement years.

Retirement financial education for people age 55+ seeking to retire well and for those retired seeking to enjoy a better retirement. We discuss retirement planning, retirement investments, taxes in retirement, retirement spending, IRA and 401k distributions and we will personally answer questions that you pose in the video comments.

While so much financial information is about preparing for retirement, what about managing your finances in your retirement years? That's exactly what we cover at Retirement Crusaders.

Neal Frankle is a retired registered investment adviser. Larry Klein is a retired financial advisor and retired CPA. They have 70 years of financial advising experience to share so that you have your best retirement years.

YouTube Video UCoU0buhwVplzXrsyf342nOg

Retirement Crusaders

June 10, 2022 1:19 PM

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