Asset Allocation Part 1

Somewhere between 40% and 100% of a fund's return is determined by Asset Allocation.  The key thing, though, is asset allocation is actually something we can control: we can't control whether the Australian share market will go up or down over the next year, we can't control if a particular manager will underperform or outperform an index.  What we can control is asset allocation.

Asset allocation is simply the proportion of assets we allocate to different investments.  At a high level this can be the split between growth assets (such as shares) and more defensive assets (such as cash).  At a detailed level we can think about how much of our share allocation we want to allocate to Australian shares vs. international shares, or even more granular such as separating our allocation to emerging market country shares against more developed nations.

Today I'm going to link to some of the sources that have helped me think about asset allocation and start by discussing the high-level split between growth and defensive assets.

Larry Swedroe has some advice on high-level Asset Allocation in his book The Only Guide You'll Ever Need for the Right Financial Plan.  Some of the tables are reproduced in a blog post by Canadian Couch Potato

I'd recommend checking out the post (or the book).  The key message is to take risk based on your "ability, willingness and need to take risk".  Ability to take risk has a lot to do with timeframe: if you have a stable income, are saving for retirement and aren't planning to retire for another 25 years you have a greater ability to take risk than someone already in retirement.  This is often what is taken into account when prescriptions such as 'your age in bonds' are made.

The willingness and need to take risk are sometimes neglected in this analysis.  For example, on the willingness to take risk, if the possibility of a 40% or 50% short-term loss will prevent you sleeping at night then a 90% or 100% asset allocation to shares is probably unwise (if nothing else because there's a chance of panic in the face of a loss, leading to selling when the market is at a low).  On the need to take risk, if you already have enough savings to last your lifetime then you can afford to take a more conservative allocation even if relatively young.  If your long-term goals require a higher return then a more aggressive allocation may be required to reach those goals.

There are some interesting approaches based on these principles.  Rick Ferri proposes starting with a reasonably conservative asset allocation when young, until you become better informed and more experienced with your degree of comfort with the ups and (more importantly the) downs of the share market. William Bernstein's short book The Ages of the Investor (a more challenging read) is in-line with this when younger.  For retirement, he focuses on having enough to cover 20-25 years worth of your usual living expenses (over and above that provided by any pension you are eligible for) in a low-risk "liability matching portfolio" and once you have "enough", your remaining assets in a "Risk Portfolio".

Some more useful sources of information include my favourite books on Asset Allocation, by William J. Bernstein:
The Four Pillars of Investing: Lessons for Building a Winning Portfolio
The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between

Other links (which I may continue to add as I think of them):

Bogleheads wiki on Asset Allocation
Rick Ferri points out that getting close to the right asset allocation is usually best, rather than worrying down to that last 3%