When building a portfolio, perhaps nothing is as important as asset allocation. Figuring out what asset classes, such as stocks or bonds, and what percentages to own are key to making sure financial goals are met by you or your clients. Good asset allocation can provide an appropriate balance between short-term stability and long-term growth potential.
That is, if investors stick with the plan.
Too often, when downturns happen, investors can shift their asset allocations. Model portfolios and sticking with a plan can help alleviate that fact. Better still, by sticking to an asset allocation plan, investors can often rebound faster and meet long-term goals.
Asset Allocation in a Nutshell
If you’re an artist, your portfolio is a collection of your works. In investing, a portfolio is a collection of assets and securities. Choosing the combination of these asset classes and individual securities is called asset allocation. Believe it or not, asset allocation could be the biggest decision investors face when building a portfolio.
Essentially, you’re dividing up the percentage of stocks, bonds, cash, real estate and other asset classes to meet your financial goals. While there is no hard or fast rule on what these percentages are, guidelines for most investors start with riskier asset classes like equities before moving into more conservative ones like bonds when they hit retirement.
The benefits of asset allocation create diversification. Different asset classes respond differently to economic and political conditions. This allows investors to smooth out returns and reduce losses. When stocks are down, bonds and their steady income can pick up the slack. When inflation spikes, real estate and commodities can provide a powerful punch.
So, getting this piece of the equation right to match risk and timeline profiles is key to making sure investors meet their goals. Poor asset allocation has sunk more than one investor.
Sticking with a Plan
Equally important is sticking with your asset allocation to let it do its job of smoothing out returns and reducing risk/drawdowns. It turns out that this is a huge issue for many investors — both in asset drift and in active decision-making.
Asset drift occurs when gains or losses in one asset class skew the asset allocation percentages by a significant amount. This can cause an investor to take on too much or not enough risk for their timelines and goals. You can see this during 2020 and the first few months of the pandemic. The below chart from RBC shows that in just a few weeks a 60/40 stock/bond split would have seen its equity portion drift lower to just 52% of assets.
Source: RBC
Another issue with regard to asset allocation is reacting to short-term downturns. Investors tend to feel losses — even if they are on paper. As a result, many will tweak their portfolio allocations on the fly when markets are down or the economy is in a recession. This has a negative effect on long-term returns.
For example, a $1 million portfolio with a 60/40 stock/bond split on January 1, 2020, would have lost about 20% of its value by March 23 — the bottom of the pandemic market. Staying put and allowing time to work its magic has its benefits. If an investor had panicked, sold their investments, and moved to cash, they would have forfeited an additional $340,000 in returns. The below chart from Vanguard highlights three potential decisions: staying the course, fleeing to cash then reinvesting later on, and staying in cash permanently.
Source: Vanguard
Model Portfolios Can Help
As you can see, reacting poorly to market conditions or allowing drift to occur can significantly impact a portfolio and its ability to fight risk and produce good long-term returns. So, how can investors and financial advisors fight this? A good starting place can be the use of a model portfolio.
Model portfolios are designed with asset allocation and risk profiles in mind. Because they offer static underlying percentages for their holdings, they can serve an important role in keeping a portfolio within these targets. If your model calls for a 10% weighting to junk bonds and it’s now at 5%, you can rebalance by selling winners who are above their targets or by adding new money to bring up the allocation.
There are plenty of benefits to doing this. By keeping investors on track, they can have significantly more assets than those investors who react to market changes. For financial advisers, it makes rebalancing decisions easy and reduces time-to-allotment decisions. Some brokerages will even do the heavy lifting — keeping assets within the model targets for you.
Costs can be lower as well with many models featuring low-cost ETFs.
Asset Allocation ETFs
These ETFs are selected based on their ability to access asset allocation models within one ticker. They are sorted by their YTD total return, which ranges from 4.2% to 14.8%. Their expense ratio ranges from 0.19% to 0.35%, while they have AUM between $240M and $2.03B. They are currently yielding between 1.1% and 4.9%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| NTSX | WisdomTree U.S. Efficient Core Fund | $990M | 14.8% | 1.1% | 0.20% | ETF | Yes |
| AOA | iShares Core Aggressive Allocation ETF | $1.88B | 10.4% | 2.9% | 0.19% | ETF | No |
| CGBL | Capital Group Core Balanced ETF | $250M | 11.3% | 1.9% | 0.33% | ETF | Yes |
| AOR | iShares Core Growth Allocation ETF | $2.03B | 7.8% | 3% | 0.20% | ETF | No |
| GAL | SPDR SSGA Global Allocation ETF | $240M | 7.2% | 4.4% | 0.35% | ETF | No |
| AOM | iShares Core Moderate Allocation ETF | $1.37B | 5.4% | 3.1% | 0.20% | ETF | No |
| AOK | iShares Core Conservative Allocation ETF | $604M | 4.2% | 4.9% | 0.21% | ETF | No |
Overall, model portfolios can serve as a great way to keep investors on track with their asset allocation. And there is a good incentive to do just that. Asset drift along with quick, rash decisions can wreak havoc on a portfolio’s ability to meet financial goals. By using a model, investors have a guideline and framework for their asset allocation and a guardrail to keep it on a steady path.
Bottom Line
Asset allocation is one of the most important decisions in investing and building a portfolio. Keeping that asset allocation steady can be equally if not more important. By using a model portfolio, advisors and investors can keep their assets on track and provide better long-term outcomes.