Asset allocation: Importance
In the previous section, we discovered what asset allocation is and we introduced the concept of portfolio management. In this section, we will see why asset allocation is so important and we will relate it to the concept of real asset classes.
Previous Scenario: Laura decided to invest $1.5 million evenly among three different assets – SmartPies, Baguette Bakery, and Rental Property. We determined that, with that asset allocation, she would get a total end return of 62.33%, or an ending value of $2,435,000.
What would happen if, instead of investing her money evenly, Laura decided to invest 50% of her $1,500,000 in Rental Property and an even 25% on the other two assets?
Let’s see how her investments would turn out:
First, let’s plot another pie chart to see Laura’s new asset allocation:
The above pie chart shows that Laura has allocated half of her investment capital to Rental Property (or we could re-name it the Real Estate asset class) and the other half to SmartPies and Baguette Bakery (or the Baked Goods asset class, since both are part of the same industry). Let’s see how this new allocation will perform and compare it with our original allocation:
As displayed above, by simply increasing her allocation in Real Estate from 33.33% to 50.00% and reducing her allocation in Baked Goods from 66.66% to 50.00%, she will achieve a higher ending value (higher return). The new portfolio (50/50*) performance will be better than that of the original portfolio (33/66*).
*Side Note: the notation “50/50” or “33/66”, in the last sentence of the example, refers to the percentage allocated to each asset class, Real Estate is first and Baked Goods second. In real life, this notation is used to communicate the percentage allocated to stocks (noted first) vs bonds (noted second). For instance, one of the most popular asset allocations is 60/40 (60% allocated to stocks and 40% to bonds).
Let’s do the last bit of math to see how Laura’s return will turn out with her new allocation:
- SmartPies Total Return: ( Ending Value of $570,000 / Beginning Value of $375,000 ) – 1 x 100 = 52.00% SmartPies Total Return
- Baguette Bakery Total Return: ( Ending Value of $600,000 / Beginning Value of $375,000 ) – 1 x 100 = 60.00% Baguette Bakery Total Return
- Rental Property Total Return: ( Ending Value of $1,312,500 / Beginning Value of $750,000 ) – 1 x 100 = 75.00% Rental Property Total Return
Now, we add up all three Ending Values and divide them by the total Beginning Value as follows:
- Portfolio Total Return: ( Ending Value of $2,482,000 / Beginning Value of $1,500,000 ) – 1 x 100 = 65.50% Portfolio Total Return
The new allocation (50/50) will yield a 65.50% total return, while the initial allocation (33/66) will yield a 62.33%; therefore, she should choose the new allocation.
There are many crucial factors to take into account when choosing your asset allocation. In this segment, we just analyzed one of them: the total return of Laura’s portfolio, or the Holding Period Return – which is the total return her investments will achieve over a period of time, in this example, it’s 10 years. However, risk should be your main focus when choosing your asset allocation.
Asset allocation is one of the most important ingredients in proper portfolio management. It helps you reduce risks through diversification. Next, we will see the factors that shape your investment personality and your asset allocation. After that, we will discover diversification and bring it all together.