 Personal Finance PowerPoint Presentation Asset Allocation. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Asset Allocation, which can be found online. Take a look at the references, resources, continue your research from there. This by James Chin updated March 1st, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, different types of investment tools. Now we're considering what is asset allocation? Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. So clearly we wanna be setting our goals, we wanna be thinking about our time horizons in terms of how much time we have to reach those goals and then as part of the strategies we put in place to reach them, we want to consider our asset allocation. To do that, we're gonna be looking at our risk tolerance and our investment horizon and so on. So the three main asset classes, equities, fixed income and cash and equivalents have different levels of risk and return so each will behave differently over time. So we can think about the basics of our asset allocation and thinking about the breaking out between the major asset categories, equities, fixed income and cash and cash equivalents and then we can go further in depth from there of course. Why asset allocation is important? There is no simple formula that can find the right asset allocation for every individual. However, the consistent among most financial professionals is that asset allocation is one of the most important decisions that investors make. So this is in alignment to some degree with the concept of diversification. Clearly there's no one size fits all because we're all unique, our financial situations are unique but we can use some heuristics and some guidelines in order to guide us to the proper asset allocation to meet our goals and our strategies. So in other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds and cash and cash equivalents which will be the principal determinants of your investment results. So what they're basically saying, it may not be as important basically to be stock picking within a particular portfolio when you're looking at the long term, it might be the case that the simple asset allocation between the principal asset classes, stocks, bonds, cash and cash equivalents be the key thing that we wanna basically focus in on and keep it in alignment with our time horizon and our risk tolerance levels. So investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest their car saving fund in a very conservative mix of cash, certificates of deposits, CDs and short term bonds. So clearly if we've got the time horizon coming up fairly soon, we might not want to be putting our money in types of assets that have a high volatility because we're hoping to use that cash shortly. If we have a longer time horizon, then of course we might use the more volatile type of tools in part because we're hoping we get a higher return at least on the long term. So an individual who is saving for retirement that may be decades away typically invest the majority of their individual retirement account IRA in stocks since they have a lot of time to ride out the market short term fluctuations. So again, this is kind of the diversification kind of concept. If we're thinking about the long term horizon, then we might put more of our money in those things that have a potential for return, which is greater and hopefully will pan out over the long term but also has more volatility and therefore they can be more risky, especially in the short term. So risk tolerance plays a key factor as well. Someone who is uncomfortable investing in stocks may put the money in a more conservative allocation despite a long term investment horizon. So, and again, there could be, you know, depends on what your particular goals are and what you are thinking about the risk and reward benefits in terms of how risky you want your investments to be placed in. So age-based asset allocation in general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. So if you have a money market account, and again, obviously, when you're thinking about your overall asset allocation, it kind of depends on your overall time horizon and so on, but when you're thinking about a particular goal, you would think that if you have a very short term goal that is a year away or something like that, that you wouldn't want all your money in, say, stocks because if there was a dip in the market, then that's gonna be a problem for your short-term goal. So the short-term goals, if you have those, you might be just putting money into some kind of savings account, like a money market where you're not gonna get a lot of earnings, but at least it's solid there. So funds fall somewhere in between. So bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor's age from 100 to determine what percentage should be invested in stocks. For example, a 40-year-old would be 60% invested in stocks. So in that way, they're trying to say, I'm trying to come up to a nice heuristic type of way, a common sense method or an easy method to determine how much percentage should be in stock versus, say, bonds, other investments. So variations of the rule recommends subtracting age from 110 or 120 given the average life expectancy continues to grow. So clearly, the time horizon that we have to save could be expanding or it could be impacted by the fact that we are living longer. As individuals approach retirement, age portfolios should generally move to a more conservative asset allocation to help protect assets. So when we're thinking about that time horizon in the future, the asset allocation mix that we have typically should be gearing normally into normal terms towards more away from riskier investments like the market onto like bonds because we're gonna need the money sooner. So achieving asset allocation through life cycle funds, asset allocation mutual funds, also known as life cycle or target date funds are an attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. So notice that you can pick basically that one fund that basically tries to do this asset allocation method. And in that way, you might get a good amount of diversification and just doing that. It almost seems too simple. You're like, can I really pick one fund and it does all my asset allocation? But you can also of course not do that. You can then do your own allocation and pick different mutual funds as we've been discussing a little bit in prior presentations. But then of course you have to be much more aware of your asset mix that you particularly have especially if you have these different funds that have different asset allocations within them so that you can determine what's the appropriate asset allocation for your given time, place and risk tolerance. So however, our critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions. So then obviously when you pick something that's just basically a set fund that that's a one size fits all kind of solution. So you might say, well, other people that might not fit, other people that have more individualized needs, you can get much more individualized in those needs. However, when you talk to most investors, financial investors, they are gonna use some heuristics about someone's basic life cycle and their earnings over that life cycle. They're gonna start off, you would think with basically a template, right? And then they're gonna try to customize over and above that template. The question then of course is going to be is it worthwhile to pay someone that's going to be trying to beat, say the market which possibly just like having a one fund type of thing or can you beat the market? Can you better allocate yourself than say a standard kind of generic template allocation which is kind of a template you would expect that these kind of age-based templates would be based on? So, and again, there's endless debates on that kind of thing. So the Vanguard Target Retirement 2030 fund would be an example of a target date fund. These funds gradually reduce the risk in their portfolio as they near the target date, cutting riskier stocks and adding safer bonds in order to preserve the nest egg. So it does that kind of allocation as you would expect. The Vanguard 2030 fund set up for people expecting to retire between 2028 and 2032 had a 65% stock, 35% bond allocation as of June 31st, 2022. As 2030 approaches, the fund will gradually shift to a more conservative mix reflecting the individual's need for more capital preservation and less risk. So in a nutshell, what is asset allocation? Let's recap this thing if we could. Asset allocation is the process of deciding where to put money to work in the market. It aims to balance risk and reward by apportioning a portfolio's asset according to an individual's goals, risk tolerance and investment horizon. The three main asset classes, equities, fixed income and cash and cash equivalent have different levels of risk and return. So each will behave differently over time. Why is asset allocation important? We know this by now. Asset allocation is a very important part of creating a balance, your investment portfolio. After all, it is one of the main factors that leads to your overall returns even more than choosing individual stocks. It's kind of funny too, when you start to listen to, if you watch like a Bloomberg or the stock, all the stock market shows, then it's interesting how often they try to come up with another word to sound more interesting than just saying, what's your strategy? Diversification, what's your strategy? A balance asset allocation and so on. And so that's often an answer or a response that they try to come up with in like creative ways to not just basically say the whole same thing, but it's an important thing to be saying. So establishing an appropriate asset mix of stocks, bonds, cash and real estate in your portfolio is a dynamic process. As such, the asset mix should reflect your goals at any point in time. What is an asset allocation fund? An asset allocation fund is a fund that provides investors with a diversified portfolio of investments across various classes with one fund. Amazing. So you could basically, that's kind of a starting point for investors saving possibly for retirement. If they're kind of new to it, they might check that out as kind of a starting point without so you don't get too overwhelmed at least at first and still can get that kind of diversification possibly. But again, you can get into all other kind of things. Should you have index funds? How much is the management cost of it and all that kind of stuff. But in any case, the asset allocation of the fund can be mixed or a variable among mix of asset classes, meaning that it may be held to fixed percentages of asset classes or allowed to go overweight on some depending on market conditions. What's the bottom line? Most financial professionals will tell you that asset allocation is one of the most important decisions that investors can make. I think, I mean, you would think almost every financial professional would be saying that. So in other words, the selection of individual securities is secondary to the way the assets are allocated in stocks, bonds and cash and cash equivalents, which will be the principal determinants of your investment results.