"The most important thing you can have is a good strategic asset allocation mix. So, what the investor needs to do is have a balanced, structured portfolio ?a portfolio that does well in different environments? we don't know that we're going to win. We have to have diversified bets."
- Ray Dalio, self-made, worth $17 billion and runs a hedge fund managing $160 billion
Imagine you own the small corner caf? (with arguably the best coffee in the area). You have a limited amount of cash to spend on growing the business, so you have to pay attention to where it goes. You have to pay your baristas, coffee bean suppliers, rent to the landlord, taxes to the government. Assuming your caf? is profitable ?do you take a profit or put it back into the business? Reinvesting the cash is probably the right decision ?do you buy new furniture to increase the seating capacity? You also have to sock away some cash in case the espresso machine breaks down.
The long-term investor faces the same fundamental questions ?where do we allocate our assets and put money to work in the best possible place? How much should we invest in stocks vs bonds vs cash? Or real estate? And how does this change over time? How do I invest most efficiently to get the most bang for my buck?
We often focus on finding the hottest stock or fund manager, but the largest component of your portfolio's returns is actually asset allocation. According to a famous study by Brinson, Hood, and Beebower done in 1986, over 90% of a portfolio's performance can be attributed to its asset allocation. Other academics have debated this 90% figure, but it is widely recognised that for all the effort you put in deciding whether you should own Tencent or Amazon ?the far more important decision is how much of your money should be allocated to stocks.
Don't over-engineer the process.
You will find an infinite number of surveys, advisors, brokers, fund managers, and people who consider themselves experts in finance with opinions on this matter and that is because financial services is a very good business (for them). There are just a few factors to consider before setting your target asset allocation:
- Objective: retirement, house, car, cat, education, general investing (general wealth accumulation)
- Time horizon: when will I look to use the proceeds of this investment
- Risk: how much can my portfolio go down in bad times (and there will always be bad times) without losing sleep at night
Answer these questions and you will be on your way to investing more intelligently. Take a goal-based investing approach to your target asset allocation by taking into account your investment objective, time horizon and your risk tolerance for you to invest better today, to live easier and retire better tomorrow.