One of the first steps to building the right investment portfolio is understanding how to use strategic asset allocation. Investors need to know the right allocation for their investment goals in order to maximize the expected returns of their portfolio while taking on the lowest amount of acceptable risk.
Risk management in a portfolio can be achieved through strategic asset allocation. It’s a way of making sure your investments are properly weighted in various asset classes to achieve a balance commensurate with your risk tolerance. That means holding a mixture of stocks, bonds and other assets weighted in such a way that the total allocation and return expectations line up with your goals.
One of the best ways to accomplish both diversification and strategic asset allocation is with ETFs. By using them strategically, investors can design a custom portfolio tailored to their needs.
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Risk Tolerance and Strategic Asset Allocation
One of the first things you might notice when beginning an investment portfolio of any type is that you’ll be asked to fill out a risk questionnaire. It may be simple, with only a few questions, or it could be more detailed if it’s being administered by a professional financial advisor. The point of this exercise is to find out what your personal risk tolerance level is so you know what percentage of your investment portfolio should be in higher risk assets, and how much needs to be allocated to more conservative assets.
As any investor knows, the first rule of investing is diversification. By utilizing a strategic asset allocation strategy, you can mitigate your portfolio’s risk exposure. It also helps investors stay disciplined and on track to accomplish their investment goals.
ETFs operate as a mixture of stocks and mutual funds in that they are liquid assets, easily traded in the market, but come with a basket of stocks, helping add diversification to a portfolio. When it comes to customizing asset allocation, most ETFs hold equities, making them no different from stocks when it comes to the asset class. Some ETFs, however, can hold a mixture of assets, giving investors instant asset allocation as well as diversification. To understand what this means, we need to examine what asset allocation is more closely.
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Asset Allocation in Practice
Let’s use two hypothetical investors and their portfolios to demonstrate how asset allocation works. Ben is a young, aggressive investor with a long-term time horizon and an appetite for the biggest gains he can get. John, on the other hand, is more conservative, with less than a decade to go before he retires.
Ben’s portfolio is designed with growth in mind and his allocation reflects it. Ben has 80% of his portfolio in stock investments while the other 20% is split in bond mutual funds, CDs and a high-yield savings account. John’s portfolio is focused more on income-generating assets rather than high-risk, high-growth equities. His portfolio contains about 60% stocks with 40% allocated to bonds and other income-producing assets.
It’s important to note that both Ben and John hold stocks as well as bonds and other assets. It’s the allocation of each that makes a portfolio aggressive or conservative. The different weights also mean that Ben and John have different portfolio return expectations. Stocks generate higher average returns than bonds, at the cost of taking on more risk. Over time, this means that any investor will need to re-adjust their allocation in order to stay within their risk tolerance level.
Investors can use some simple math to make some predictions about their own portfolio and the kind of returns it might produce. As an example, we’ll make some predictions about Ben and John’s portfolios. Let’s say that stocks are expected to gain 10% annually while bonds should return 4% annually. To find out the portfolio’s total expected return, we need to multiply the weighted amount in stocks by the expected return and add that to the weighted amount in bonds multiplied by its expected return.
Ben’s portfolio:
80% stocks with a 10% return and 20% bonds at a 4% return.
(0.80)(0.10) + (0.20)(0.04) = 8.8% expected return
John’s portfolio:
60% stocks with a 10% return and 40% bonds at a 4% return.
(0.60)(0.10) + (0.40)(0.04) = 7.6% expected return
From the above example, we can see that the difference in allocation resulted in a difference of 1.2% annually in portfolio returns. In actual practice, investors may have many more asset classes with varying return expectations that need to be added to the equation. And annual return expectations can change as well, requiring investors to stay up to date with their portfolio and its asset allocation. Because stocks tend to out-gain bonds over time, investors need to monitor the asset mix of their portfolio as well.
ETFs can play the role of stocks or bonds depending on what investors need in their portfolio to achieve the right balance. As an asset class, ETFs are incredibly diverse, giving investors more options.
The Bottom Line
A portfolio needs to be designed with asset allocation firmly in mind. Regardless of the portfolio’s design, if it doesn’t match your risk tolerance level, it’s ultimately the wrong build for your goals. Investors should also keep in mind that proper diversification means including stocks, bonds and other asset classes in your portfolio regardless of risk tolerance and investment goals. It’s the allocation of these assets that ultimately decides how much risk a portfolio contains.
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