Asset Allocation?

Today’s post comes from Akash Sky, who blogs at about investing and increasing his net worth to $99K.

Disclaimer: This post does not constitute investment advice. It is for information purposes only. We recommend you take professional financial advice.

Asset Allocation?

Asset allocation is a fancy term to describe what investments you buy.  If you buy good investments, you reduce risk and increase the money you make.  Likewise, if you buy bad investments, you increase risk and reduce the money you make.

Step 1: Determine your portfolio goals

The first step is to determine what you want to achieve with your portfolio.  Typically people either want to do one of the following:

Capital Preservation

Capital preservation involves investing your money where the primary goal is to prevent loss at all costs.  What this means is that your goal is to simply match inflation and avoid losing a single penny.

Modest Capital Appreciation

Modest capital appreciation means that your primary goal is to prevent loss and your secondary goal is to make some money.  What this means is that you are willing to make some safe investments in order to earn a little bit over the inflation rate and avoid losing your money.

Capital Appreciation

Capital appreciation means that your primary goal is to make money and your secondary goal is to prevent loss.  What this means is that you want to take some calculated risks in order to make a lot of money but also make sure that you do not lose too much during a market downturn.

Aggressive Capital Appreciation

Aggressive capital appreciation means that your primary goal is to make as much money as possible.  You are willing to take on huge risk in exchange for huge rewards.  During strong periods in the market, you will make excessive amounts of money, but will also lose a lot during downturns.

Step 2: Determine what asset combination helps to achieve your goals

For the purpose of this post, we’ll just refer to stocks & bonds as the major components of a portfolio.  A stock is ownership in a company.  What this means is that you share in profits and share in losses.  A bond is debt in an institution.  Basically, it’s an IOU stating the terms of how much money they owe you and how they plan to pay you back.  Typically, stocks are much riskier than bonds – in the event of a bankruptcy, bondholders will get paid first.  The graphic below shows the priority that a company has in paying out their cash.

For more information on specifically what funds to invest in, you may want to speak with a financial adviser if you are not well versed in investing.

Capital Preservation

When aiming to preserve your capital, you want to make sure that your portfolio is heavy in bonds.  You want to hold very few stocks in favor of the less risky bonds.  Ultimately, this will limit your losses during market corrections and allow your portfolio to maintain its value over time.  For example, you may want to invest in 90% bonds, and 10% stocks.

Modest Capital Appreciation

When looking to safely grow your capital, you want a mix between stocks and bonds, with the bond portion of your portfolio having slightly more weight.  You may want to invest in 60% bonds and 40% stocks.  This will allow you to capture returns from strong periods in the market while not beat you up too hard during recessions.

Capital Appreciation

For capital appreciation, you want to be stock heavy.  This is because stock has the highest potential for gain.  You may want to invest in 20% bonds and 80% in stocks.

Aggressive Capital Appreciation

For the aggressive portfolio, you don’t want to have any bonds.  You want to capture as much upside as possible and want your portfolio to be invested mostly in stocks..  For this type of portfolio, I would go with 100% stock.

Step 3: Move things around to lower your taxes

Typically, whenever you earn money you are taxed.  This really cuts into your return so you want to lower the taxes that your portfolio generates.  In order to create a tax efficient portfolio, you have to first understand how taxes work.  I’ve created a nice guide on US income taxes, but unfortunately do not have anything for the UK audience.  However, has some nice starter information for UK residents.

The gist of how it works is that your income is taxed either at a long term capital gains rate (lower) or ordinary rate (higher).  Your rate depends on your income and whether you are a citizen in the UK or the US.  The way to beat the system is to figure out what kind of income is taxed at long term capital gains vs ordinary rate.  For example, bond interest is usually taxed at your ordinary (high) rate, whereas stock dividends are usually taxed at the long term capital gains (low) rate.  Once you figure out what you have and what its taxed, you can start moving things around.

Taxed Advantaged Accounts

In the US, we have tax advantaged accounts like Roth IRAs, Traditional IRAs, and 401Ks.  The UK has ISA’s and Pensions.

Typically, what you want to do is simply take all of your investments that are taxed heavily and put all of them into the taxed advantaged account.  Once your tax advantaged accounts are full, put the rest of your investments (the stuff that is not taxed as hard) in a taxable account.  It’s that simple.

Step 4: Re-balance every few years & Relax

Because the price of assets constantly change, over time you will notice that you have some winners, and some losers.  Your winners have gone up in price, whereas your losers have fell in price.  For example, lets say that you started with a stock heavy portfolio with 20% in bonds and 80% in stock.  After a market downturn, you found that your portfolio is now sitting at 40% in bonds and 60% in stock, (due to bonds going up in value and the stocks going down in value).  At this point you want to re-balance.

When you re-balance your portfolio, you are simply resetting your ratios to your original setting.  What you would want to do is sell your bonds such that you only have 20% left and take the proceeds and purchase stock such that your final portfolio is sitting at 20% bonds and 80% stocks.

Re-balancing is good for your portfolio because you are automatically “buying low and selling high”.  This is because a segment of your portfolio can only rise above your original threshold if it rises in value.  As a result, you “sell high”.  Likewise, a segment of your portfolio can only go below your original threshold if it drops in value.  As a result, you “buy low”.

In Conclusion

Asset allocation isn’t something that is set in stone.  You can change it whenever you want.  However, it is important to realize that the way you choose to allocate your assets will directly affect your bottom line (returns & risk).  At the very least, I suggest you to take advantage of your tax favored accounts and invest how you see fit.

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