Asset Allocation – the perfect recipe in more ways than one
The late Anthony Bourdain, world famous celebrity chef, was quoted as saying that the worst thing he had ever eaten was a McDonald’s chicken nugget. That’s a pretty bold statement considering he was known for consuming exotic dishes like sheep testicles, ant eggs, and raw seal eyeballs. But, of course, not everyone agrees and McNuggets have been a staple on the McDonald’s menu since 1983. This shows, as we all know, that food preferences vary greatly across the globe. As should asset allocations.
What’s for dinner?
Even if you are no culinary genius, you know that ingredients are key to creating the perfect meal. Having said that, when I throw together tomatoes, garlic, onion, and pasta, it doesn’t quite taste as good as the restaurant down the road’s penne Napoletana. There are 3 possible reasons for this, 1. The ingredients could differ, 2. The proportions of the ingredients could differ, or 3. The way in which it is cooked differs. Each of these reasons affects the final flavor and overall satisfaction that you get from the meal.
Now, as you read this you know that we certainly don’t profess to be culinary masters here at Zoe, but we do know a little something about personal finance and investments, and the analogy of cooking a meal goes a long way to explain the concept of asset allocation.
When you decide what to cook for dinner, there is a plethora of information that you need to know before you can get started. For instance, how many people will you be feeding, how many courses will you be making, does anyone have allergies, what size portions do you need… the list goes on.
In a similar vein, when you are deciding on the asset allocation of your investment portfolio, you need to start with the high-level stuff. The 3 main areas being:
- Time horizon
- Risk tolerance and capacity
These 3 factors will be used to determine the mix of assets that you choose, just as the allergies of your guests will affect what ingredients you buy.
The ingredients of your asset allocation are called asset classes and subclasses.
For each asset class and subclass, you will need to choose how much of each to include in your portfolio. Again, this decision relates back to your goals, investment time horizon, and risk.
Choosing the right mix of assets in your portfolio is not as simple as throwing a few ingredients into your shopping cart – it requires time, analysis and regular review.
There is no such thing as the perfect asset allocation, as each investor is different and is looking for different outcomes from the portfolio, just as each person has a slightly different flavor preference. What is delicious for me might not be for you. Your main aim with your asset allocation is to find a balance between different asset classes and subclasses that allows you to achieve your required returns without taking on more risk than you are comfortable with.
That sounds straightforward, but it’s a pretty tough task! As a starting point, you can use a questionnaire like this one from momanddadmoney.com that helps to create a starting point from which you can adjust.
Another option is to get guidance from a professional financial planner. They’ll be able to sit with you and go through all it is that you want to achieve with your investments, what you value the most, what your goals are, the time horizon of your investment strategy and your risk profile. This process will give you both the information necessary to create the right recipe (portfolio) for you.
Keeping a balanced diet
All parents and grandparents will know what I mean when I talk about the toddler food strike. The three-year-old that loved avocado last week simply refuses to eat it this week. Carrots go from position number 1 to not even a consideration, and mash potato suddenly hits the top spot when it wasn’t given a second glance 2 months prior. It turns out that this type of change in culinary preferences is not specific to toddlers. Our taste buds tend to change as we get older or when our hormone levels change (for instance during pregnancy). It’s not much different when it comes to our goals or our risk tolerance, what we wanted (or needed) three years back might not be what we want this year.
Important to note, that this does not imply that you should change the recipe (your asset allocation) just because time has elapsed. If anything, the best recipes tend to stand the test of time. Nevertheless, we have talked about change and transformation at length in our weekly blogs, and we couldn’t be more aware of the fact that all of us are ever changing. As a result, our investment goals, time horizons and risk tolerance also change, and we need different things from our investments at different stages.
The one thing that should be constant, is reviewing your asset allocation at regular yearly intervals. If the market readjusted your asset allocation without your permission (for instance if stocks fell a lot and bonds rose), or if your specific situation changes (i.e. selling a house, retiring, one spouse stops working etc.) then it is important to rebalance to bring your portfolio back to its original recipe. Adjust the mix of assets to make sure that your mix is right for the you of TODAY and not the one from 20 years back.
Regardless if you decide to cook up your own recipe or seek guidance from a financial advisor, it is important to remember that although we change, we need to keep our emotions in check. Reacting to rash emotions like fear and greed can cause havoc in your portfolio. Any changes you make to your mix of assets needs to be thoughtful, rational and strategic. Easy to say, but often hard to do!
*All investing is subject to risk, including the possible loss of the money you invest. **The projections or other information generated by Zoe Financial, Inc. regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.