Asset allocation is a tool that allows you to minimize your losses whilst still benefiting from potential gains, by spreading out any risk. But what is asset allocation and how can you effectively use it? Click the video below from Chief Investment Officer Kieran Osborne, or read the text beneath it to learn more.
The intent of Asset Allocation within portfolio design is to identify the right ‘mix’ of investments that align with your financial goals. It is the portfolio allocation across stocks, bonds, cash and other assets such as real estate. Well-designed portfolios help produce more consistency in returns.
At Mission Wealth we design portfolios with target asset allocations that provide an appropriate level of risk and return based upon your personal financial plan and your risk tolerance.
Why is asset allocation important?
Portfolio design – the allocation across asset classes – is the single largest determining factor in portfolio returns, with studies showing it contributes over 91% of the total return on a portfolio.
At the broadest level, asset allocation can be thought of as the split between stocks and bonds. Stocks tend to be more growth oriented and volatile – meaning they experience larger swings in value, both up and down – whereas bonds tend to act as an anchor of the portfolio, providing more stability and also providing a relatively consistent income yield.
Historically, stocks and bonds have often moved in opposite directions to each other, particularly during stock market sell-offs – so having a dedicated allocation to core bonds may help protect against large market downswings and ultimately produce more consistency in returns from one period to another.
The chart below illustrates how a well-diversified asset allocation can produce more consistent returns over time. Let's take a look at a full 10-year cycle. This one is from 2008 through to 2017.
Why this ten year period?
It represents a time period that represents both good and bad years, which is fairly typical for how things tend to play out for investments. Sometimes we do experience longer stretches of up or down markets, but this is a good example that has a mixture of returns. This data specifically uses index returns as a measure of how various asset classes performed.
Each colored square represents the annual performance of an asset class over a 10 year period, and includes the Great Financial Crisis of 2008. Asset classes are ranked each year from best performing to worst performing. The purple highlighted boxes represent a portfolio comprised of 60% stocks and 40% bonds.
The first observation is that this portfolio is never the best performer but also never the worst. It consistently ranks in the mid to top end of the pack, year in, year out.
In 2008, bonds were the best performing asset class, returning 5%, while stocks were down significantly across the board. As you can see, a diversified portfolio helped mitigate the negative stock market returns in 2008.
In 2009, stocks reversed course and rallied significantly, while bonds trailed and were the worst performing asset class. In this instance, the portfolio comprised 60% stocks and 40% bonds participated in the upside of stocks and outperformed bonds.
The reality is the performance of each individual asset class can differ significantly from one period to the next. But a well-designed portfolio, allocated across asset classes can produce much more consistent results.
Indeed, over the 10 year period illustrated, the same portfolio comprised 60% stocks and 40% bonds produced about ¾ of the return of the S&P 500 but with about 60% of the risk.
We also highlight the 10 year performance of other portfolios – ranging from 20% stock exposure to 80% stock exposure. You can see they consistently rank in the mid to top end of the pack.
This underscores the important role asset allocation plays in portfolio construction.
Finding the right mix, or asset allocation, is a critical step in ensuring your portfolio performs in align with your risk tolerance and produces more consistency in returns on the way to achieving your long-term financial goals.
If you'd like to learn more about how you can incorporate more asset allocation benefits into your portfolio, please reach out to our experienced and dedicated team.
Disclosures
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods. Diversification cannot ensure a profit or protect against a loss.
Investments in commodities may be affected by the overall market movements, changes in interest rates and other factors such as weather, disease, embargoes and international economic and political developments.
Diversification helps you spread risk throughout your portfolio, so investments that do poorly may be balanced by others that do relatively better. Neither diversification nor rebalancing can ensure a profit or protect against a loss.