Asset allocation is a basic discipline for diversifying your portfolio, especially if you have a long-term investing strategy. Relative valuations are important.
Asset allocation involves dividing up an investment portfolio by asset classes, such as stocks and bonds
“It’s all relative.” We’ve probably all heard this phrase applied to a variety of questions and topics. It’s the verbal equivalent of a shrug. But in investment planning and portfolio strategy, a “theory of relativity” absolutely comes into play. It’s called asset allocation, or more specifically, asset allocation based on relative valuations.
Asset allocation takes a portfolio pie and dedicates slices of varying sizes to different asset classes. Perhaps you give a healthy slice to stocks, another slice to bonds, maybe a sliver to cash, and so on. Asset allocation that’s well thought out goes hand-in-hand with portfolio diversification and long-term investing. It takes several factors into account, including individual goals, time horizon, risk tolerance, volatility, market performance, and more.
Let’s look at a few pointers on asset allocation.
Think of a stock, a bond, or an overall market. None of these exists in isolation. The same applies to broader asset classes, like stocks in general or bonds in general. Most assets have prices, and therefore, they have a value that can be compared to other assets.
As part of asset allocation, investors may look at a particular asset class, not in terms of absolute values, but in the context of other asset classes in their portfolio. They try to determine if, for example, the equity positions have become expensive (overvalued) or cheap (undervalued) relative to their holdings of bonds and other fixed-income assets.
The basic idea: If you’re looking at an asset class that’s performed well compared to other investments, there may be an opportunity to trim that position and shift the proceeds into something that may be on the verge of outperformance, or something that’s trading cheaper relative to your original positions.
Established equity index benchmarks like the S&P 500 Index (SPX) can help in making asset allocation decisions. Are S&P 500 stocks overvalued, undervalued, or somewhere in between? That depends (it’s relative). Are you comparing the S&P 500 to, for example, European stocks, emerging market stocks, or fixed-income assets like Treasuries and corporate bonds?
Remember, proper asset allocation is based on relative valuations. Price-earnings ratios and other metrics can help indicate if a stock is overpriced or underpriced. As an investor, you can add value incrementally within the context of assets beyond stocks.
The stock market consists of dozens of industries or sectors and thousands of companies. The S&P 500 Index, for example, has 11 sectors: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Real Estate, Health Care, Industrials, Materials, Technology, and Utilities.
Valuations in each of these sectors can be compared to other sectors, individual companies, and the broader market. Other ways to slice and dice equity valuations include:
For equities, look at valuations broadly or holistically. It’s not just about the valuations of one sector, but the valuations of multiple sectors as well as other asset classes. You’re looking to understand which are expensive compared to those that are cheap.
How much of a portfolio to devote to equities may be one of the most important decisions you’ll make in asset class selection. One common guideline: You can subtract your age from 110 and invest that percentage in equities. For example, if you’re 50, you might consider putting 60% of your money in equities. Of course, each investor should consider their personal circumstances to decide the appropriate allocation.
Even after you allocate and diversify, the job is just starting. What was diversified a year ago may be concentrated now. It’s important to check your portfolio mix regularly and see how changes in market capitalization, international versus domestic holdings, and other factors may have altered your asset balance.
When it comes to bonds, pay attention to interest rates. That’s the primary driver of value, relative or otherwise, in fixed-income assets. Fixed income in the United States is a different animal compared to Europe, Latin America, and other regions. You may find there’s opportunity to gain greater yields if you go abroad.
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Many investors build diversified portfolios by sticking to equities and fixed income. There’s nothing wrong with that. Although stocks may hold a greater potential for growth, bonds often provide more potential for income, making them an appealing choice for those nearing retirement or who are more inclined toward conservative investment styles.
A bond’s interest rate depends on a few key risk factors, including time to maturity (longer is riskier) and the borrower’s credit (the U.S. government is assumed to be safer than an indebted startup). As with stocks, you can choose bonds from different sectors and geographies, although each comes with different risks.
One note of caution on asset allocation and bonds: be careful about “reaching for yield,” or taking risks that aren’t commensurate with the yield you’re reaching for. With outsize yields, there’s often a higher probability of default or some other credit event that could materially impact the bond or bond fund.
Asset allocation and portfolio diversification aren’t just about owning stocks and bonds. You can often find opportunities as the market evolves to snap up assets that are relatively cheap or sell assets that may have gotten expensive. If assets in other parts of the world are trading at lower valuations than in the United States, you might want to look at those opportunities.
Think about casting a wide net. You can adapt as markets change and avoid getting confined to a traditional 50/50 or 60/40 allocation box. By understanding valuations across asset classes, you can increase the chances of success in your long-term investing goals. After all, the aim of a diversified portfolio is to have some positions zig while others zag.
If nothing is really cheap among stocks and bonds, it might be time to consider alternative asset classes such as commodities or real estate. Alternative assets can help you diversify against extreme valuations in traditional equities or fixed income.
Real estate assets are available outside of buying actual property. For example, consider looking at publicly traded Real Estate Investment Trusts (REITs). Crude oil, gold, and other commodities can be accessed through futures contracts and certain exchange-traded funds (ETFs). Like REITs, these trade on exchanges like shares of stock.
Asset allocation and long-term investing requires, among other things, a point of view, or many points of view. When you take a point of view, it’s got to be relative to something. Some behaviors are advantageous to a long-term investing plan, particularly discipline.
Discipline is essential for a relative allocation mindset. You’re already looking for opportunities and keeping close tabs on market conditions. Watch for periods of extreme emotion and volatility and try to avoid letting those conditions distract you from your plans. When people are greedy, you become fearful, and vice versa.
It’s also a good idea to seek out sounding boards—people who can help you bounce ideas around. TD Ameritrade managed portfolio experts can help you tailor investments to any number of life and investing considerations: age, timetable, appetite for risk, and more.
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