Asset allocation defines the percentages that are invested in various types of assets, like stocks or bonds.
It is the foundation for traditional investing that seeks to lower risk through diversification.
There are pros and cons to asset allocation. The pros are improved risk management, structure, past data availability, low implementation cost, alternative investment potential, and simplicity while the cons are lower returns, decreased potential, complacency, and assumed suitability among investors with different needs.
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What Are The Benefits Of Asset Allocation?
The benefits of asset allocation are many as outlined below.
Pro: Asset Allocation and Risk
Risk is lowered by investing money into different types of assets based on an asset allocation model since certain types of assets go up when stocks go down.
Such assets are referred to as non-correlated assets in financial lingo.
The classic example of non-correlated assets is stocks and bonds.
When stocks drop in price, defensive investments usually increase in price. During bear markets, investors flee to the certainty of U.S. Treasury bonds, for example. This drives the price of bonds up as stocks decline in price.
Even though stock investors can’t avoid losing money in the stock market during bear markets, overall portfolio risk is lowered. The diversification into bonds helps investors prepare for bear markets through simple ongoing diversification thereby reducing emotional investing.
Pro: Asset Allocation Models
Asset allocation models provide structure for both investors and financial advisors.
This structure reduces the temptation to invest too high a percentage of capital in overpriced assets that are often the result of over exuberant markets near the end of bull markets.
Adhering to a structure lays the foundation for an entire portfolio planed around desired risk and return based on a personal wealth plan.
Pro: Asset Allocation Performance Data
Past performance data can be evaluated for asset allocations into major asset classes. This is done through indexes that represent asset classes.
The S&P 500 represents the U.S. stock market, for example. The ETF SPY represents the S&P 500.
The iShares 7 to 10 year Treasury bond fund IEF represents intermediate U.S. Treasury bonds.
Similar indexes and funds exist for all major asset classes. Past performance data is available now for all major asset classes.
We know that past performance will not be the same as future performance because various factors influence the performance of investments, such as the economy and interest rates. We can, however, use past performance data for reasonable estimates of future performance, especially when we consider recent and current market and economic environments.
Past performance data provides a huge benefits for investors using asset allocation models for major asset classes. Investors can even check past performance of asset allocation models created by experts, such as the All Weather Portfolio constructed by Ray Dalio, on websites like PortfoliosLab.com.
Pro: Alternative Investments with Asset Allocation
Traditionally, asset allocation models have invested in stocks and bonds only. Alternative investments such as gold, commodities, and real estate are now part of many more sophisticated asset allocation models.
Investors who wish to use more advanced investing strategies can do so with asset allocation models that are more robust.
Pro: Asset Allocation Portfolio Costs
Asset allocation models provide a way for individual investors to invest at little to no cost. Most brokerage firms offer no commission transaction costs for ETFs and index funds.
While professional wealth management can add a level of knowledge and expertise to investing, many financial advisors use more traditional asset allocation models for their clients. Self directed investors can often implement an asset allocation model similar to the one the financial advisor model implements at a lower cost.
Pro: Asset Allocation Is Simple
Buying a well diversified portfolio following an asset allocation model is easy, period. There’s no trying to evaluate investments or predict stock market direction.
The challenge comes in the discipline of taking an afternoon to learn how to choose and implement an asset allocation model so you have the confidence to do so, and then following the chosen model.
Nevertheless, the simplicity of asset allocation investing is a huge pro making it an ideal beginner investing strategy as well as suitable for advanced investors as addressed ahead.
Problems With Asset Allocation
While there are many pros, there are some problems with asset allocation models.
Con: Asset Allocation Templates
Asset allocation models are templates. They promote a one size fits all model that is supposed to work for everyone with certain parameters, such as age or risk tolerance.
One con is that they tend to treat all 50 years old the same, for example. A 50 year old with a million dollars in retirement savings has vastly different investment goals than a 50 year old with $100,000 in investment savings.
Desired lifestyle and spending habits are other influences not considered in asset allocation models.
Con: Asset Allocation Underperformance
Lower risk doesn’t come without a price. The stock and bond asset allocation model with lower risk than an all stock portfolio will underperform during stock bull markets.
Since stocks outperform bonds over very long time frames, asset allocation models that hold bonds underperform over long time frames.
It’s important to note that stocks increase in price more than they decrease in price over long time frames, but bonds reduce portfolio volatility along the way.
Con: Asset Allocation Over Diversification
Truly great investors get that way by investing in what they’re good at.
Warren Buffett and his right hand man, Charlie Munger, were experts at choosing company stocks.
Peter Lynch was similarly an expert at stock selection.
Bill Gross was an expert bond investor.
The old fashioned way to invest was by choosing good investments within a concentrated area of expertise, such as stocks, bonds, or real estate, that are likely to rise in price. Asset allocation is the opposite of this; it’s template investing, despite the many pros of asset allocation above.
It’s important to consider, however, that truly great investors are extremely rare making this asset allocation problem almost completely irrelevant.
Con: Asset Allocation Return Expectations
Many investors follow an asset allocation model based on past returns over a decade or less while making retirement plans around the returns repeating themselves.
This is usually a problem because different economic environments produce different results for different asset classes and economic environments go through major changes from one decade to the next.
Con: Asset Allocation Can Lead to Avoidance
Asset allocation investing is so easy that it can lead to complacency. No matter how investors chose to invest, it’s important they learn how to understand investments so they can make appropriate decisions. This includes whether an asset allocation model is appropriate, and, if so, the best type of asset allocation model.
Fixed Vs Tactical Asset Allocation
This post has been focused on fixed asset allocation since this is the most popular type of asset allocation used.
Keep in mind, however, that there are both fixed asset allocation and tactical asset allocation strategies. The later rotates the asset classes held based on various factors, such as market cycles or economic conditions. Tactical asset allocation can overcome many of the cons of more traditional buy and hold asset allocation as seen by the results at Allocate Smartly for both fixed and tactical asset allocation models.
Pros and Cons of Asset Allocation Summary
As you can see, there are both pros and cons to asset allocation investing. Given the simplicity and low cost of asset allocation investing, it can make a lot of sense for many investors who understand the risks and potential returns.