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Investing

How To Create An Asset Allocation Plan

Calvin Lo

With so many different asset classes out there, how do you decide which ones to and how much to buy?

One of the most important steps in creating a robust investment portfolio together is deciding which type of assets (or asset classes) to include in it. Will you just be 100% in stocks? Or will you also invest in bonds, real estate, commodities, or maybe even gold or cryptocurrencies?

Once you have settled on the asset classes you want, you then need to decide how much you want to ideally hold in each asset class.

Your asset allocation would generally depend on your goals and risk tolerance, but would likely be the main determinant of your overall portfolio volatility and returns.

88% of the volatility and returns from a diversified portfolio can be traced back to asset allocation.

According to research by Vanguard

Before you jump in and spend countless hours on researching individual stocks, consider first settling on an asset allocation which might save you a lot of heartache down the road.

What are Asset Classes?

According to Wikipedia, asset classes are basically groups of financial instruments that have similar characteristics and behave similarly in the marketplace.

Equities (a.k.a. stocks or shares), bonds, real estate, and commodities are some of the more common asset classes. Anything else of value can be considered alternative assets including but not limited to cryptocurrencies, art, wine, private equity, hedge funds, etc. The list is non-exhaustive.

  • Equities/stocks/shares are basically part ownership of a company or entity.
  • Bonds are akin to a loan to the issuer in exchange for interest or coupon payments.
  • Real estate or property can range from ownership of the entire house, building or land, to part ownership through REITs (real estate investment trusts).
  • Commodities include a wide range of raw materials and food like gold, silver, copper, oil, natural gas, sugar, etc. As the name suggests, a commodity is a basic good used in commerce that is undifferentiated and interchangeable with other goods of the same type.

What is Asset Allocation?

The first step to putting an asset allocation plan is to understand a little bit more about the assets we have to choose from as an investor.

Asset allocation in simple terms, just means determining the proportion of different asset types or classes in a portfolio. Theoretically, different asset classes behave differently in any given market situation or event, so putting different asset classes together can reduce overall portfolio volatility.

For example,

  • Equities do well when the economy is growing and businesses are booming.
  • Bonds do well when interest rates decline, like we have seen over the past few years because of Quantitative Easing (QE) by central banks.
  • Real estate does well when businesses are expanding and/or loans are cheap due to low interest rates.
  • Oil prices is supply/demand-driven and typically increase in price when there are supply chain disruptions/shortages or when demand increases during business expansion cycles.
  • Gold is commonly viewed as a safe haven and typically does well during times of economic crisis.

Creating Your Own Asset Allocation Plan

Before you even start buying any assets for investment be it equities, bonds or real estate, you need to have at least a rough asset allocation plan so that you know what kind of return, risk, and volatility to expect. Being caught off guard is no fun, and may even derail your investment journey if it causes you to bail and sell out prematurely.

The most important step is to determine your investment objectives, i.e. your goals and risk tolerance. Are you investing for retirement, generate a passive income, or just to make a quick profit? Each of these goals come with very different risks and thus may require different asset allocations. For example:

  • If you’re young and investing for retirement, you might want to consider putting the majority of your money into equities which are long-duration assets. Over the long-term, equities have historically provided the best returns but also comes with high volatility especially in the short-term.
  • However, if you’re close to retirement or already retired and are investing to generate passive income, you might want to accept lower returns in exchange for lower volatility and less risk. Since you’re no longer receiving income from your job, it wouldn’t be wise to take too much risk on your limited capital since your lifestyle might be affected if you lose too much money.
  • And if you’re just investing to earn a quick buck and have little or no commitments, you can invest heavily in extremely risky assets. However, you must be keenly aware of the risks and be mentally prepared to lose everything.

One way to create your own asset allocation plan is to start with one of these portfolio allocations proposed by professional investors at Portfolio Charts. For each portfolio listed, the website provides nice visualisations for key stats like expected annual returns, portfolio growth, drawdowns, rolling returns, long term returns, etc.

Find the portfolio that matches your expected risks and returns, and start from there. You can then fine-tune the asset weightings as you go along in your investment journey and as your objectives change.

My Asset Allocation Plan

Creating your first portfolio asset allocation plan doesn’t have to be complicated. Back in 2016, I started with the simplest Classic 60-40 portfolio, comprising of around 60% in Vanguard Total World Stock ETF (VT) and 40% in Vanguard Total Bond Market ETF (BND).

Along the way I added real estate and commodities into the portfolio through the Vanguard Real Estate ETF (VNQ) and the Invesco DB Commodity Index Tracking Fund (DBC). At one point, my portfolio was 60/20/10/10 in Equities/Real Estate/Bonds/Commodities.

However, my portfolio evolved because I felt that my asset allocation was too conservative for me. Although I’m not that young anymore, I still have a pretty long investment horizon so I wanted to be more aggressive in my allocation and take more risk by increasing my exposure to equities.

After many tweaks over the years, my allocation now stands at roughly 80/8/8/4 into Equities/Bonds/Real Estate/Alternatives, where Alternatives are Gold and Cryptocurrencies.

In anticipation of tapering and rising interest rates, I’ve reduced my bond exposure substantially. I also have real estate in the form of REITs, some gold and some cryptocurrencies as inflation hedges. I’ll probably try to maintain 80% exposure to equities I guess until I’m 50 at least.

Concluding Thoughts

Having an asset allocation plan is important for us to manage our portfolio risks against expected returns. However, it’s not necessary to have the perfect allocation in place before you start investing.

The market moves really fast, and so should you. Your portfolio asset allocation should also change depending on your age and life situation.

The important thing is having a plan, doing your best to stick to it, and adapting if things change or are not working out as you expected.

Don’t enter the markets without a plan.

Useful Resources

Disclaimer: This is not financial advice. I am not professional financial advisor nor do I work in the finance industry. Anything I write here is purely my personal opinion. Please do your own research and due diligence before investing into anything. All investments come with associated risks. Best to consult a financial advisor if you’re still unsure.

For more investing resources, see my Referrals page.

Disclosure: This post may contain affiliate links and I may get a commission when you click on the links or open an account through the links, at no additional cost to you. I only recommend products or services that I have personally tried and have found useful.