How do you decide how much to invest in stocks, and how much to invest in bonds?
What about gold, Bitcoin, REITs, properties, etc?
In this guide, I'll explain how to go about in asset allocation and share what mine looks like.
Everything starts off with the big picture, the strategy, and not the nitty gritty. In fact, studies have shown that asset allocation itself drives a huge amount of an investor's portfolio return, up to 90% in some studies.
By choosing the right mix of asset classes like stocks, bonds, gold, cash, real estate, cryptocurrencies and so on, you can control how risky your portfolio is, and how much in both short-term and long-term returns you can expect to earn over time.
Imagine choosing an asset allocation like choosing an estate to buy a house in - do you like somewhere central like Queenstown or somewhere closer to the airport? In many cases, before choosing which house to buy, it's important to choose the estate your house will be located because it drives most of the pricing.
Different asset classes will offer different risk and return characteristics. For example, borrowing an example below, you can see that depending on how much risk you choose to take in your investments, you can expect to earn a higher expected return.
From the graph, you can see that asset classes on the bottom left like money market funds, or cash, have the lowest expected returns but also lower risk. Moving further right in the graph increases the level of risk in the investment, but also expected returns.
Note that there's a clear trade-off between risk and returns, as the market will naturally balance between asset classes to optimise for the best risk-return trade off.
There's no best asset allocation
A natural question is what is the best asset allocation to maximise my returns? The answer is it depends.
It depends a lot on an individual's risk preferences, goals and the time horizon for investment. An individual with a longer investment timeframe can afford to take more risks, grow their portfolio more aggressively, and earn a higher return over time.
Taking a conservative portfolio as an example, a historical average return of a 100% bonds portfolio is 6.1% annually from 1926 to 2020.
Adding some risk to the portfolio by introducing 20% stocks in the mix brings that average annual return to 7.2%, at the cost of higher and longer temporary losses.
A less risk-adverse investor can allocate even more to stocks, perhaps bringing his portfolio to 80% stocks, therefore increasing his average annual return to 9.8% at the cost of a potential 34% drawdown.
Based on the above example, you can see that while an investor can possibly earn a higher return, he's taking on higher volatility risk and potentially see deeper and longer drawdowns than the more conservative investor.
Choosing an asset allocation
Now that you've understood the trade offs between risk and returns, it's time to choose an asset allocation, i.e. how much of your portfolio gets allocated to which asset classes.
I'd first start off with understanding your goals. What is the investment amount going to be used for? Is it retirement? Is it for a house? Is it for wedding? Or is it for general wealth accumulation?
A related topic is timelines, because retirement could be many decades off and a wedding could be in the next 5 years. Establishing the goals and timelines early makes it easier to allocate your assets as you're clear on how much risk you can afford to take, and ride out the periods of temporary drawdowns.
A sum of money that's funding your retirement 25 years later can take higher levels of risk than a sum of money that's for emergencies. In this case, it might be useful to separate these two pots of funds, and invest them appropriately.
Let's take for example in a typical scenario where you want to invest for retirement and leave some for savings in case of emergencies:
Pot 1 - Emergencies
- Timeframe: Possibly immediate
- Liquidity: Instantly
- Risk: Low
- Allocation: 100% cash or 100% high yield savings account
*liquidity refers to how fast you can convert your assets into cash for spending
Pot 2- Retirement
- Timeframe: 15-30 years
- Liquidity: Some lump sum + monthly drawdowns
- Risk: Medium to High
- Allocation: Depending on risk appetite, but personally 80% stocks and 20% bonds
Finding balance with changing allocations
Asset allocations are not set in stone forever - they can change with time or with changes to one's personal life.
For example, during your early career and stage of career growth without a family, you can take much higher levels of risks as there are less liabilities to pay. You could go 100% in stocks, or even riskier investments like cryptocurrencies and earn possibly higher returns.
As you settle into a family or take on more commitments, or grow your portfolio into a sizeable amount, you might want to reduce risk to protect more of your capital. During this time, it makes sense to shift into a more defensive portfolio like selling stocks and reduce risk.
Perhaps as you grow older too, you might want to slowly shift into a more conservative portfolio to protect your capital - you don't want to see a 40% loss when you're nearing retirement as you might panic sell and realise those losses.
Implementing asset allocation in investments
You can implement your asset allocation in various ways, and typically, most people do it through funds with their financial advisor, robo-advisor or DIY.
One great way is to implement it through a diversified index fund or ETF that tracks the broad market. For example, a total stock market index fund diversifies your money across thousands of companies, tracks the stock market and gives you exposure to stocks as an asset class without taking on idiosyncratic risks (i.e. losing all money when one company goes bankrupt).
Combining that with a total bond market index fund, or a similar bond index fund or ETF, gives you a two-fund portfolio that can help you allocate between stocks and bonds in a really simple way.
Sophisticated investors might want to slice and dice within the asset class, for example, over-weighting towards Asia or buying more technology stocks or funds.
US investors have a target date retirement fund that is basically a single fund that invests in multiple stocks and bond funds and gradually shifts the asset allocation in favour of defensive investments like bonds to reduce the volatility of the portfolio over time.
My asset allocation
As of today, my asset allocation is something like this on my cash portfolio:
- Cash - 15%
- Stocks - 70%
- Bonds - 0%
- Crypto - 15%
To describe this on a high level without going too much into details, I hold exposure to the stock market mainly through diversified and passive index funds/ETFs that track companies globally. I do no stock selection because I couldn't outperform the market in the first five years of my investment journey.
I also hold 15% cash for both emergencies and investment reserves but no bonds. I think bonds are way overvalued at current prices and if interest rates go up in future, bond prices are expected to fall. Furthermore, unlike companies which can re-invest profits or payout dividends, bonds offer little upside as economies recover.
Lastly, crypto is 15% of my portfolio mainly because I have made quite a bit during the crypto bull market and I have been quite isolated from the recent dip as I was positioned quite well. Nonetheless, this is house money that I don't want to cash out so it's mainly as a opportunity to take higher levels of risks for higher returns.
I think planning your investment strategy around asset allocation is great for simplicity and it helps guide your investment decisions without over-exposing yourself to risk beyond your comfort levels.
If you are unsure how to choose an asset allocation, between 60/40 or 80/20 for example, just pick the more conservative one first and adjust later.
Alternatively, create two portfolios (especially if you're using a robo-advisor) and see which one you like more over a period of time. You would get a blended rate of return but it helps you see which risk level you're more comfortable with.
During bull markets like what we are currently seeing, the riskier portfolio will outperform markedly, but when the tide changes, a more defensive portfolio will prevent huge drawdowns.
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