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Asset allocation is the process of dividing your investment portfolio among different asset classes, such as stocks (equities), bonds (fixed income), real estate or commodities.
It’s a fundamental concept in investing, and it’s one of the most important decisions you’ll make when building your lazy portfolio.
But why is asset allocation so crucial? The primary reason is that different asset classes tend to perform differently over time and under varying economic conditions. By diversifying across these classes, you can reduce your overall portfolio risk and potentially improve your long-term returns.
Think of it like building a diversified meal. You wouldn’t eat only carbohydrates, would you? You need protein, vegetables, and healthy fats for a balanced diet. Similarly, your investment portfolio needs a mix of assets to weather different market climates.
Strategic vs. Tactical Asset Allocation: What’s the Difference?
It’s important to distinguish between two main types of asset allocation:
- Strategic Asset Allocation: This is your long-term plan. It’s based on your risk tolerance, time horizon, and financial goals. It represents your ideal portfolio mix, which you’ll aim to maintain over the long haul. For example, a strategic asset allocation might be 60% stocks and 40% bonds.
- Tactical Asset Allocation: This is a short-term, active approach that involves making adjustments to your strategic asset allocation based on market conditions or economic forecasts. The goal is to take advantage of perceived opportunities or to reduce risk during periods of market volatility. For example, you might temporarily reduce your stock allocation and increase your bond allocation if you believe the stock market is overvalued.
At LazyPortfolioEtf.com, we focus primarily on strategic asset allocation. Why? Because numerous studies have shown that a well-defined strategic asset allocation is the most significant driver of long-term investment returns.
Tactical asset allocation, while potentially rewarding, is much more difficult to execute successfully and often leads to underperformance due to emotional decision-making and market timing.
The Power of Strategic Asset Allocation (and Behavior)
Research consistently demonstrates that asset allocation accounts for a significant portion (often cited as 90% or more) of a portfolio’s long-term performance. The specific asset classes you choose and the percentages allocated to each are far more important than the specific securities (like individual stocks) within those classes.
However, there’s another critical factor: investor behavior. Even the best strategic asset allocation can be derailed by poor investment decisions, such as panic selling during market downturns or chasing hot stocks. Sticking to your long-term plan and resisting the urge to react emotionally to market noise is crucial for achieving your financial goals.
Think of it this way: Your strategic asset allocation sets the course, and your behavior keeps you on that course, even when the seas get rough.
Practical Examples of Asset Allocation
Let’s look at a few simple examples (for US investors) of asset allocation based on different risk profiles:
- Conservative Portfolio:
- 30% Stocks (Global ETF like VT)
- 70% Bonds (Aggregate Bond ETF like AGG or BND)
This portfolio is designed for investors with a low risk tolerance and a short time horizon.
- Balanced Portfolio:
- 60% Stocks (Global ETF like VT)
- 40% Bonds (Aggregate Bond ETF like AGG or BND)
This portfolio offers a balance between growth and income, suitable for investors with a moderate risk tolerance and a medium time horizon.
- Growth Portfolio:
- 80% Stocks (Global ETF like VT)
- 20% Bonds (Aggregate Bond ETF like AGG or BND)
This portfolio is geared towards long-term growth and is appropriate for investors with a high risk tolerance and a long time horizon.
- Aggressive Portfolio:
- 100% Stocks (Global ETF like VT)
This portfolio is only appropriate for investors with very high risk tolerance and very long time horizon.
Important Note: These are just examples. Your ideal asset allocation will depend on your unique circumstances. It’s always a good idea to consult with a qualified financial advisor to create a personalized investment plan.
Remember, at LazyPortfolioEtf.com, we believe in keeping things simple. Focus on creating a strategic asset allocation that aligns with your goals and risk tolerance, and then stick to it. Don’t let market noise or the temptation of tactical investing derail your long-term success.
