When you sit down to meet with your financial advisor you’ll
probably talk about asset allocation. This conversation is usually accompanied
by a colorful pie chart illustrating the blend of investments contained within
your account(s). Too often, this important topic is brushed over or
misunderstood. What do the wedges in the pie represent? Have they changed size?
Why does it matter? In today’s post, we’ll review essential asset allocation terminology
and highlight the importance of the topic.
Three Wedges: Equities, Fixed Income, and Cash
In its most basic form, an asset allocation is broken down
into three key asset classes: stocks, bonds, and cash. Each asset class has its
own risk profile, return expectations, and investment considerations.
- Stocks – Many investors and advisors use the term “equity” and “stock” interchangeably. When you buy common stock in a company, each share represents a fractional ownership interest in that company – or, an “equity” stake. Equities typically have high return expectations, but are the most volatile of the basic asset classes.
- Bonds – Bonds are also often referred to by a different name: “fixed income.” A bond represents a loan made by an investor to a company or municipality. In return for this loan, the bond issuer will pay the bond holder a fixed stream of income – hence the moniker “fixed income.” Bonds are associated with a lower level of risk and return than their equity counterparts.
- Cash – Cash is often held for spending needs or the preservation of principle. Market timers will sometimes raise or hold cash in pursuit of “buying opportunities.” Cash is often held in money market funds or FDIC insured deposit accounts, but can also be invested in secure vehicles like certificates of deposit (CDs). Cash has the lowest return potential – but the lowest risk profile of the basic asset classes.
Putting it All Together
An investor’s unique blend of stocks, bonds, and cash is
referred to as their asset allocation (or asset mix). A target
asset allocation is based upon each client’s unique needs, expectations, risk
tolerance, and time horizon – all within the context of market conditions and
economic outlook. An investor with a long timeline and penchant for risk would
stereotypically have a high allocation to stocks. Conversely, an investor with
high loss aversion and near-term objective would have more bonds or cash
equivalents.
By design, different asset classes will behave differently
in varying market conditions – providing intrinsic hedging along with
diversification. A target asset allocation will, to a certain extent, determine
the risk and return character of your portfolio. As such, asset allocation is
an essential component of investment policy and oversight.
More Wedges?
Of course, the fun doesn’t stop there. Each of the basic
asset classes can be further granulated to achieve diversification of exposure,
risk, and return. There are small companies, big companies, domestic holdings,
international investments, emerging markets, government bonds, etc. As such, some
asset allocation illustrations can contain more than three basic wedges. In
such a case, the array of colors can easily overwhelm, potentially distracting
from the conversation. Try and keep an eye on the big picture by considering
the three basic asset classes, while also observing their underlying
constituents.
Why it Matters
It is important to develop an asset allocation strategy that
works for you and your needs. It should also honor your shifting tolerance for
risk and volatility. In addition, over time, as different investments move in
different directions, the wedges in the asset allocation pie chart will expand
and contract. As such, asset allocation isn’t a “set it and forget it”
decision.
As is the case with most planning topics, asset allocation requires ongoing diligence and oversight. So, look a bit closer at the next pie chart you see. Or, if you need help understanding your current mix of investments, contact us.