Partner and Financial Planner at Blue Rock Dravo Bay. Financial Planning is just that, planning for the expected and the unknown. My strongest commitment to clients is to be a familiar, trusted face during their time of need.
We recently wrote about the concept of asset location and how it differs from asset allocation. You may recall that asset location is a tax minimization strategy that places your assets in the most tax-efficient investment accounts.
Asset allocation, on the other hand, focuses on optimizing returns while spreading out investment risk, by positioning your portfolio holdings across different sectors. In a nutshell, the goal is to maximize return for each investor’s given level of risk.
Both investment strategies are an important part of a well-managed retirement portfolio. Let’s dive a little deeper into the concept of asset allocation as a strategy to optimize your portfolio health.
Diversification among multiple asset classes
The asset allocation strategy we apply to your portfolio is based on your financial goals (like ideal retirement age), your age today, income need in retirement, comfort with risk, and other factors.
Asset allocation seeks to diversify your holdings and balance your portfolio. In essence, this means that your money is spread out (i.e. allocated) among different asset classes, market capitalization thresholds (i.e. related to a company’s earnings), and geographic location.
The goal with asset allocation is to optimize your portfolio with non-correlated assets to increase the risk-reward return. non-correlated assets improve investment performance by reducing risk. Your portfolio is therefore usually diversified among individual stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs), and more.
Asset allocation has been studied by many financial professionals but one research study that stands out is “Determinants of Portfolio Performance” by Gary Brinson, Brian Singer, and Gilbert Beebower who sought to explain the impact of asset allocation on pension plan returns.
Their study examined quarterly returns of 91 pension funds over 9 years. Their notable claim was that asset allocation explains approximately 93.6% of the variation in a portfolio’s quarterly returns. What do these findings mean for you?
It means that we have to keep constantly improving the risk-to-reward trade-off through asset allocation and the critical importance to remain invested in the market. Let’s take a closer look at how we look at risk-reward planning.
How we apply risk-reward planning to stay the course
Many folks are tempted to chase high returns by investing all their money in higher-risk investments. For long term returns and portfolio health, we rely instead on calculated risk management.
Think of risk/reward decisions as analogous to a speedometer. If you drive really fast with disregard for the speed limit, you are taking a calculated risk that you may arrive at your destination faster (i.e. higher returns through high-risk investments) but any bump in the road will be felt at a high magnitude. Some bumps may be large enough to cause a crash, so to speak, if your level of risk was simply too high.
The balance we seek to strike is applying just the right amount of risk to realize significant rewards for our clients while minimizing exposure to crashes. By reducing our speed and moving in a safer and more strategic manner, we increase our chances of arriving at our intended destination with little to no collateral damage.
We know that any investment comes with a relative amount of risk; some investments are riskier than others. When we add two investments together that are both “high return” and “high-risk,” the overall risk of our portfolio is relatively high. Whereas, the risk/reward ratio of your portfolio allocations is lower if we combine one “high return, high-risk” investment with one that is “low return, low-risk.”
We also manage risk by investing a portion of your funds in non-correlated assets. A non-correlated asset is an asset whose value isn’t tied to larger fluctuations in the traditional markets. The idea behind non-correlated assets is to lower your portfolio’s overall risk profile and volatility level, infusing safety into your portfolio.
The power of compound interest
Success in the market relies on two things:
- Your net investment return over time
- The length of time you remain invested
Because most of us have time on our side, we benefit from the power of compound interest, something Albert Einstein is reputed to have called the eighth wonder of the world.
Compound interest is earned on your principal and previous interest payments; that is, interest accumulating on interest. Compound interest accrues over time, where interest begins accumulating against the combined amount.
While it’s challenging to explain how this works with words, take a look at the graph below which shows how $10,000 grows over 10 years, assuming an average annual return of 6% with no additional contributions to the original investment of $10,000.
Let’s take a look at another example with a longer time horizon.
You invest $100 in the stock market and you earn 10% on your investment. At the end of the year, you’ve earned $110. Next year, instead of starting at $100, you get to start at $110 and the market earns another 10%. Your new total becomes $121 earning you $11 in interest this year— this additional dollar earned over last years $10 is compounding interest at work for you. While $1 is much in year 2, in year 30 your compound interest snowballs into $1,586.
The bottom line? Stay invested!
Why asset allocation matters
Thanks for joining us to learn more about how we take great care to ensure the long term health of our clients’ wealth. We believe in long term investment in the stock market as the best predictor of a secure and comfortable retirement life.
If you’re new to investing, we recommend that you identify your investment goals, start investing early, understand the power of compounding interest (tax-free for some accounts), and leave the complex asset location and asset allocation to a trusted partner. As your financial advisor team, we’re committed to both the short term and long term health and sustainability of your portfolio. We are here to help answer questions about your existing portfolio or to start optimizing your investment strategy. Contact us today.