Asset Allocation

The most important factor in the long term growth of your investments is your personal asset allocation. It has been documented by the Brinson study at University of California in the mid 1990s with millions of iterations that the overall asset allocation contributes 92% of your rate of return. The specific equities, bonds, and mutual funds only adds 6% to your return.

Your asset allocation starts with your risk tolerance, which is a subjective category of how much volatility you can take and how much of a loss you are willing to suffer. In simpler language, “Can you sleep at night?” See our Risk Tolerance Questionnaire of 10 questions to see how you gauge yourself and what investment category you most likely fall in. There are no right or wrong answers. Generally, the younger you are, the more aggressive you can afford to be. The benefit of time will correct and make up for any mistakes made. The older or more closer to retirement that you are, the more conservative you should be, primarily to preserve your capital. A rule of thumb is that your age should mark the % in bonds or fixed income. Once you have determined your risk tolerance category, it is necessary to consider the timing of your goals. The closer they are dictates that you should be conservative and not risk your capital. Some people will try to swing for the fences if they are short the capital they need. This is not recommended because most likely one can lose a lot more of their capital.

The universal metric for measuring the risk of investments is called the standard deviation. Risk = Volatility. Statistically speaking:

66% of volatility is within 1 std deviation
95% of volatility is within 2 std deviations
99% of volatility is within 3 std deviations

The lower the standard deviation relative to other investments, the less risk incurred, but it also means a lower rate of return. Generally speaking, you earn an increased return for taking on more risk. Another measure of risk is known as Beta. This is usually compared to a market index. A beta of .8 means that the investment is only 80% as volatile as the index. A beta of 1.25 translates that the investment is 25% more volatile than the index.

Once your risk tolerance is known, you can apply it to your asset allocation which is the % distribution of equities / fixed income / cash equivalents in your portfolio. An example of a Moderate asset allocation of 70 / 25 / 5 means that this investor would have 70% of their portfolio in equities, 25% in bonds, and 5% in cash or money market.

The asset allocation distribution is applied to what is known as the Efficient Frontier, where one end of the curve is based on an absolute risk free investment such as US Treasury bonds which will pay only a relative low interest rate. The other end of the Efficient Frontier curve could be based on a basket of precious metals or commodities in Zimbabwe which would be very volatile and have to pay a relatively high return in order to attract any investors. There is no free lunch. If you want a higher return, you must take on more risk.

 > Risk > Return = no free lunch

Many investors try to take on more risk than they can handle. In a bear market that we experienced in 2008 & 2009, many investors that stayed in the market lost almost 60% of their capital and were shaken out of the market. A lot of them will not go back in, or are very reluctant. It is not unusual for investors to migrate down the curve to less risk and lower returns. This is especially true as one ages and gets closer to their goals and becomes more conservative.

Whatever your asset allocation, remember to make sure all of your investment have the five most important parameters of:

Control, Visibility, Accessibility, Liquidity, and Flexibility

If you want advice on understanding your risk tolerance and / or want to develop an appropriate asset allocation for your portfolio, call us at Quest Financial Services Inc. for a complementary consultation.