Asset allocation is about identifying different asset classes (including stocks, bonds and cash), deciding how much of each you want to own and choosing investments that represent these asset classes for your investment portfolio. Asset allocation does offer several benefits, but it is not the ultimate investment solution. Like other investment solutions, it has its limitations.
Below are the myths about asset allocation that investors should stop believing:
Asset allocation protects you from the bear market
Asset allocation has a two-fold goal: to set a long-term risk-and-return expectation for your portfolio and to reduce the probability of a huge loss along the way. It is not surprising that the more risk you decide to take, the higher the return you can expect. But asset allocation is also known as a way to diversify risk. The idea is that each asset class carries different risks, which helps lessen the total long-term risk in a portfolio.
And while asset allocation reduces the probability of a large loss in a down market, it does not totally prevent a loss. In an economic downturn, your portfolio will also go down according to the amount of total risk you hold. In 2008, for instance, almost all asset classes except bonds moved down together.
Frequent rebalancing is necessary
When you rebalance your portfolio, you sell the asset class that has grown beyond its allocation and buy the class that is below your goal. But there is no advantage to overtrading your portfolio. Annual rebalancing gets your portfolio back in line with its long-term target and gives you almost the entire benefit that more complex rebalancing methods provide. The rebalancing date could be the first day of the year, your birthday, or any important day in your life. What matters is that it is consistent.
More funds mean more diversification
If you own more funds, it will not necessarily increase your diversification, as those funds could be from the same investment category and hold the same securities.
Being diversified means owning asset classes that have fundamentally different risks. In addition, asset classes with expected returns that are higher than the inflation rate, such as REITs and international stocks, are good to own.
Tactical asset allocation is all about market timing
This asset-allocation strategy shifts asset-class weights based on near-term predictions of returns. It may last from a few days to a few years. People want to believe that somewhere, somehow, someone can tell them where to put their money now, and they will pay a good amount for that advice.
Critics sometimes dismiss this strategy as “market timing” and claim that it can be a losing game for average investors. Depending on the way it is carried out, it can be just that. However, there are many different approaches to tactical asset allocation, ranging from making small and incremental adjustments to an otherwise unchanging asset allocation, to making wholesale switches based on various factors.
There is an optimal asset allocation
There is no such thing as perfect allocation – at least not one that can be known in advance. Some people get hung up on details such as how many international stocks they should have. In the long run, what really matters is the percent you have in stocks and bonds. Everything else is just an add-on.
Some investment firms promote computer models they claim can pinpoint an optimal asset allocation based on your answers to a questionnaire. But finding the appropriate asset allocations requires you to know yourself and life circumstances. You should analyze your net worth, employment and income, spending and saving rates, housing situation, the income you will need from savings, when you will need it and who is getting the remainder when you are gone.
Beyond these factors, the right allocation is the one that you can live with during a deep and prolonged bear market. It is a mix where you will be ready to buy more stocks as they fall and sell stocks as they rise.
Lastly, a sensible allocation considers taxes. Some investments belong in tax-sheltered accounts, while others work well in taxable accounts. For instance, tax-inefficient real estate investment trusts (REITs) and high-yield corporate bonds should go in a tax-sheltered account.
What do these myths mean for investors?
These myths do not mean that you should not consider asset allocation as an investment approach at all. But they do mean that you need to be careful when allocating your assets. Choose an asset allocation that suits your long-term needs based on the amount of risk you think you can withstand. Plus, you need to have an asset-allocation strategy in place, as that is the key to building a solid foundation for future investing strategies. Done properly, asset allocation will enable you to build a portfolio that balances risk and return.