Yo dudes! This is Neil, and thanks for reading Neil$letter.
It’s been a minute since I published! On a personal note, there’s been a lot of good stuff happening since my last post. Many of you will know that I got married recently! 😍
I want to stay focused on financial stuff here though, so let’s dive into today’s topic. As a reminder, the following discussion is not investment advice.
What is Asset allocation?
I want to introduce you to a basic investing concept that you’ll want to know about even if you’re a hands-off investor. The concept is called asset allocation, and it refers to how much of your portfolio is spread across different types of asset classes.
When you think about investing, you might think mostly about stocks (or even a crummy old savings account, money market fund, or CD at a bank). But there’s a ton more options out there. For example, here are some different types of asset classes:
Stocks (aka “equities”)
US stocks
US large cap stocks
US mid cap stocks
US small cap stocks
US growth stocks
US value stocks
International stocks
similar sub-categories as US stocks above
Bonds (aka “fixed income”)
Corporate bonds
Government treasuries
Junk bonds
Treasury Inflation-Protected Securities (aka TIPS)
Municipal bonds (aka munis)
Alternate / other
Real Estate Investment Trusts (aka REITs)
Gold
Crypto
CO2
…and tons more! There are always new categories of asset types to explore. While stocks, bonds, gold, and real estate have been around a long time, some of the newer financial innovations include things like cryptocurrencies and carbon dioxide (CO2) markets.
For our purposes, though, let’s keep things really simple and think about 3 basic categories: stocks, bonds, and “other” (or what I like to call diversifiers).
Why does this matter?
Asset allocation is a central piece of the investing puzzle. It determines: your risk:reward profile, the trajectory of how your financial wealth will grow, how much you can lose in a worst-case scenario or gain in a best-case scenario, and more. By understanding a bit about modern portfolio theory and how uncorrelated assets work in your favor, you can improve your outcomes as an investor. (Note: by asset correlation, I mean: if stocks go up, do bonds tend to go up with them? Historically, bonds are slightly negatively correlated with stocks, so they actually tend to go down when stocks go up, and vice versa. We’ll talk more about all that in a future post.)
How to find your asset allocation
Most brokerages give a breakdown of your asset allocation for you - often in a monthly or quarterly statement, or in an account summary or overview type page.
But, let’s say you have several accounts spread out across various financial institutions, and you want to build a spreadsheet to keep track of your total asset allocation (hint hint, I recommend this). Here’s an example with some made-up numbers:
You have a TIAA-CREF 401k account from an old employer with $12,000 in stocks and $2,000 in bonds.
You have a Fidelity Roth IRA account that has $10,000 in stocks, $200 in bonds, $500 in gold, and $800 in REITs. You also have a taxable account with Fidelity that has $1,000 in stocks and $2,000 in bonds.
You have a Robinhood account with $10 in stocks. (The backstory here is that you bought Gamestop and Bed, Bath & Beyond stock with $100 but the two positions collectively lost 90% of their value. Womp womp. Thanks for nothing, r/wallstreetbets!)
You have a Coinbase account with $800 in crypto.
You have a CD with a local credit union worth $1,000 (we’ll consider this “fixed income,” or a type of bond).
So you plug all that into the spreadsheet, and see that you have:
Stocks: $12,000 + $10,000 + $1,000 + $10 = $23,010
Bonds: $2,000 + $200 + $2,000 + $1,000 = $5,200
Other: $500 + $800 + $800 = $2,100
Your total financial assets add up to $30,310. We divide each category total by this number, and find that stocks are 75.9%, bonds are 17.2%, and other categories are 6.9%. That’s your asset allocation across all of your financial accounts!
What “should” your asset allocation be?
This brings us to the perennial questions of: well, what should my asset allocation be? If you’re asking this question, you’re on the right track. And, spoiler alert, it’ll keep coming up as you review your finances and investments year after year. I think it’s a key question every investor should grapple with.
I can’t give you the answers, because everyone is different. So read up online and consult some trusted pros. At a minimum, you want to know what kind of risk and what kind of reward each asset class entails. And almost always, the higher the potential risk, the higher the potential reward (and vice versa).
In general, having a higher percentage allocation to stocks is considered more “aggressively” allocated, while having bonds is seen as a play for relative safety (from the turbulence of the stock market) and income. Other assets, like gold, crypto, and real estate can be seen as diversifiers, with stocks and bonds usually being the main show.
I would say that generally, asset types go from least risky to most risky as follows:
cash/money market/CDs/T-bills (very safe, generally low reward)
bonds (lots of different types, but generally seen as a “risk-off” asset)
gold (moderate risk, moderate reward)
stocks (lots of different types, but as a broad category generally are higher-risk and higher-reward)
REITs (slightly higher risk than stocks, potentially higher reward)
crypto (very risky, but also potentially very high return)
If you’re in your teens or 20s, you might want a diversified basket of higher-risk, higher-reward stocks, REITs, and some crypto. Those 3 categories could add up to 100% and you’ll likely be OK so long as you haven’t put all your eggs into one basket.
On the other hand, If you’re in your 50s or 60s, you may want considerably less in high risk assets, such as stocks - maybe 40% to 60% is better, with the rest being allocated to bonds, gold, and cash alternatives.
What I can say is that, for me, being aggressive with my asset allocation and investment choices has paid off handsomely. (The caveat here is that’s only true because I was younger and had plenty of time on my side and a high tolerance for risk.) On the other hand, when I’ve been overly conservative (for example, moving lots of money into bonds thinking that the stock market might crash), I have been “punished” by missing out. In general, it’s considered best practice to not overly change your asset allocation in any given year. Find the right mix for you, and stick with it.
Wrapping Up
Ultimately, you want to know yourself, and a take a thorough look at your entire financial life when deciding how much of your portfolio to put into which category. When in doubt, check out the asset allocation for a target date fund that is appropriate for your age.
For example: let’s say you’re 30 in 2023, and you would like to retire around 2060. You google “2060 target date fund” and find Vanguard’s 2060 Target Retirement Fund, traded under ticker symbol VTTSX. You scroll down to Portfolio composition. There, you see that the experts at Vanguard think the “average” person with a retirement date that far off in the future should have: 54.5% US stocks, 35.9% international stocks, 6.9% US bonds, and 2.7% international bonds. The asset allocation for VTTSX right now is thus: 90.4% stocks, and 9.6% bonds.
We’ll talk more about target date funds next time, but one cool feature they have is that they automatically adjust their asset allocations as you age. So you won’t hit 65 with an overly-risky portfolio, you’ll hit 65 with an age-appropriate one.
If you’d rather not DIY your investment decisions, including asset allocation, then absolutely consider a target date fund, a robo-advisor, or a pro to help guide you!
Thanks for reading. If you’ve found this helpful, please do the social thing - like, comment, & share!
-Neil
PS. One thing I’ve been enjoying recently is Season 2 of Somebody Somewhere. If you have access to Max (formerly HBO Max), give it a look! (If you missed Season 1, start there obvs)
Edit: confirmed for season 3, as well! :-)
Very thorough and easy to digest! Thanks for breaking it down so well! :D
Great discussion about asset allocation, lots to think about, and excellent tips, thank you!