The Financial Advisor’s Guide to Asset Allocation

I had a financial advisor reach out to me recently with some questions about implementing some changes to his firm’s asset allocation models. It served as a good reminder about the importance of asset allocation in the investment process. Few investment decisions matter more than asset allocation but many investors choose to focus their attention elsewhere.

In the past, many brokers or financial advisors didn’t spend much time worrying about asset allocation because they were so focused on security selection and selling products. After speaking with this advisor I made some notes and here’s what I came up with for the financial advisor’s guide to asset allocation.

A perfect allocation is the enemy of good allocation. There’s no such thing as a perfect portfolio, rebalancing interval, tax deferral strategy or investment mix. The perfect allocation will only be known in hindsight. In the grand scheme of things, it won’t matter much if you have 5% or 10% in a certain fund or asset class. Half the battle is having a plan in the first place. There are no right or wrong asset allocations for your clients but there are a number of things to consider:

  • Which asset classes, sub-asset classes, and strategies will you use?
  • Will you practice a strategic allocation, a tactical allocation or a combination of the two?
  • What will you own and why?
  • What won’t you own and why?
  • When will you decide to make changes and why?
  • How will you implement your plan and how much maintenance will be required?
  • Which types of funds or securities will you use to gain your desired exposures?

You have to be able to explain it. Since there is no perfect asset allocation, you must be able to explain to your clients which types of investments you’ll be putting them in and why. Any number of strategies will perform just fine if you leave them alone but if your clients can’t understand how they work or why they own certain investments it’s going to be difficult to get them to stay the course over time. Simplifying complex topics is one of the more underrated roles of being a good financial advisor.

Ongoing education is key. To create useful portfolio allocations you have to understand your clients and they have to be able to understand you. Portfolios shouldn’t be designed for simulations, but for the people who will be investing in them. Education on asset allocation is all about setting the right expectations, teaching about market history, conveying the present while preparing clients for the future. The teaching and communication process never stops.

Some educational considerations:

  • What’s the best way to explain your investment philosophy and individual strategies?
  • Do you understand your investments enough to explain them?
  • Can you put it in simple enough terms that people outside the finance world can understand it?
  • How do you plan to communicate going forward to ensure clients stick around long enough to see it through?

Understand your risk factors. Asset allocation is about diversifying your risks, but you first have to define what those risks are before creating portfolios. Diversification is never going to completely eliminate risk but asset allocation can help you manage it. It’s not so much the individual asset class or fund risks that matter as much as how they all work together to create or reduce overall portfolio risk. Historical relationships and correlations are constantly changing over time so the goal should be to have several assets that will act differently than one another without becoming overly-diversified (the law of diminishing returns can come into play here).

A few more considerations:

  • What’s the most efficient way to own the specific asset class or risk factor you’re looking to gain exposure to?
  • Do you understand the right risks to prepare for?
  • What’s a reasonable cost to pay for those exposures?
  • How do you balance the short-term sanity of your clients with their long-term goals and needs?

Asset allocation is hard. It can be challenging to come up with a long-term allocation policy, implement it and then have the discipline to stick with it. Asset allocation is a simple concept yet it’s extremely difficult to see through in real time because (a) there will always be something in your portfolio you hate at the moment, (b) there are tons of temptations and distractions from other investors, the markets and investment products and (c) long-term policies tend to get thrown out the window at the height of a strong bull market or the depths of a severe bear market.

Creating good policies and then following through with them increases your odds of success exponentially but it’s not easy exhibiting this type of behavior. This can be even harder when you’re dealing with other people’s money. What you want investors to do versus what they can reasonably be expected to do are two very different things.

Some final considerations when thinking about a client’s asset allocation:

  • You should have a very good reason any time you make a change to a well thought out asset allocation policy on behalf or your clients.
  • The majority of the time, doing nothing is the best decision you can make.
  • Knowing your clients is extremely important because you can’t simply fit every single one of them in the same allocation mix.
  • The best allocation is the one you (and your clients) will stick with.

You also have to remember that we always live in uncertain times. Asset allocation is how you manage your money without knowing what the future holds. Asset allocation is for long-term people.

Further Reading:
7 Simple Things Most Investors Don’t Do


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    “Asset allocation is hard”. Which is why Buffett and Bogle both advocate 100% S&P ??

    • Ben

      Buffett’s is more like 90% S&P and 10% cash for his heirs and Bogle says take your age and put that amount (as a %) in bonds

      • FUЯ ION

        But given current levels of interest rates, wouldn’t you say bonds are mathematically equivalent to cash? So a Stocks-Cash portfolio w̶i̶t̶h̶ ̶s̶̶̶o̶̶̶m̶̶̶e̶̶̶ ̶̶̶g̶̶̶o̶̶̶l̶̶̶d̶̶̶ would be good enough?

        • Mark Massey

          This is what I think which is why I have no fixed income. My clients have cash (15 to 30%) and individual equities…20 to 30 positions.

          • mugabe

            Did they have that during the last crash?

          • Mark Massey

            Do not know. I have been an IAR since 2011. But if I was managing their portfolios then, it would have depended on where rates were. If I thought you could lose principal in fixed income, I would have had them in cash instead of fixed income, like now. So for an 80-20 account, the 20 is cash instead of FI now.

          • Flying Robot

            Interesting… everyone approaches the art of portfolio construction a bit differently. I don’t have any special credentials, but I really enjoy the investing world.

            The implications of this approach, I think, would include higher overall returns (assuming bond returns are < cash), but also bigger portfolio drawdowns vs 20% bonds (in most situations.) From a behavioral standpoint, it may be a bit more difficult for the client if and when equities decline substantially, so you might have to do more to prepare them for that eventuality (my personal portfolio has the same issue… don't think there's a way around that if you want to hedge on rates. (LT bonds could be the investment of the year… but I think I'll pass!)

          • Mark Massey

            The Barclays’s Aggregate bond index was up 2.6% in 2016. The S&P 500 index was up about 10%. Non-domestic large cap indices were negative. Roughly, my average client account for 2016 was up around 21 to 22%, net of my fee. My personal accounts were up right at 30% as I had more energy-related equities and less cash than did my clients.

          • Flying Robot

            Nicely done! S&P was 12.0% with dividends, which were a shade over 2% as I recall. I figure from the profiles you stated you have a lot of younger clients with high risk tolerances (compared to folks near retirement); unless you rely on some other means to reduce risk. Do you run some sort of TAA approach? At 50, I do a 65/35 & though I can’t claim to be pure buy and hold, I effectively am. Returned 11% last year, and i think drawdowns should be no worse than a standard 60/40; better in most cases, past performance etc.

          • mugabe

            It seems to me that an 80/20 or even 70/30 account requires holders of those accounts to have a very good tolerance for very sizeable drawdowns … which will come (which is basically what Flying Robot says below!).

          • Flying Robot

            I see, makes sense. I have 2/3 of my fixed income in a stable value fund at near 3% (did just fine in 2008, very diversified base of providers with solid balance sheets) and 1/3 in Intermediate Treasuries (I can handle 5-10% losses here if they happen, but I like the portfolio implications for the scenarios nobody expects.)

            I consider cash to be fixed income. It’s like a bond with zero duration, eh?

        • Michael Jones

          I don’t think so in general, regardless of interest rates. Of course there are differences between bond ownership methods, so that affects some of the outcomes.

          If you OWN the bond out right and can hold it to maturity, then mark to market doesn’t matter. And if it is anything with a positive return (or a TIP that does as long as inflation stays positive), then you have at least some forward movement. So it’s not the same as cash. You can loose purchasing power (making less than inflation), but you aren’t getting ZERO either, which is what cash gets, assuming it’s in a non-interest account.

          A bond fund on the other hand, has both mark to market risk and redemption risk. Both of which can force the fund to mark down the value of assets based on current market conditions and/or people exiting a fund and forcing sales of underlying assets. I both of those cases you can have very negative effects on your total bond holding.

          Cash never ‘gains’ or ‘looses’ actual value, but it certainly looses purchasing power. In a stocks-cash portfolio you are pretty much GUARANTEED to loose purchasing power on your cash, so unless you are holding it for opportunity, you are decreasing your total return.

      • Mark Massey

        If you are 55 to 60 now and follow Bogle’s advice, you may very well run out of money if you live an average life span.

        • Ben

          right, I’ve always thought Bogle’s idea was a tad on the conservative side

          • Mark Massey

            Bogle still states this is the way to go for most people. I totally disagree…you have to consider the period you are in. Currently, rates are at or near 75 year lows. To invest over half of your retirement savings in fixed income now if you are age 55 to 65 is a colossal error in my opinion.

          • Flying Robot

            Bonds serve particular portfolio functions; it is risky to reach for return at the expense of safety. I’m not sure what you want to replace bonds with? Much depends on how much you have saved and how much you need, but I would think it’s still plenty safe to use bonds though I agree that duration should be a consideration (and we won’t see the returns of the past 30 year bull.) Two things that I mull over a lot:
            – Rates may stay near 75 year lows for a long time, even with the Fed dumping MBS reserves shortly. A lot depends on ephemeral ‘natural’ interest rates.
            – There are bonds that still have a high level of safety. ST Treasury or Investment Grade (even Int Trsy ~ 5 year) funds are not likely to take a very big hit even if rates rise 2-3 points. CD’s/Bond ladders (held to maturity) tied to your spending needs & Stable Value funds (many returning 2-3% currently) both effectively nullify interest rate risk and many have been slightly outpacing inflation.

    • mugabe

      Forming a plan is relatively easy – following it is hard. Same is true of buy and hold.

  • Ben, if you didn’t know the history of returns for stocks, bonds, etc., what asset allocation would you choose?

    Nick de Peyster

    • Ben

      I think it’s very important to understand the structure of the securities or asset classes you plan on owning so knowing the risk inherent in bonds and stocks would still help this process even if you have no clue about their historical performance

    • Mark Massey

      Nick, you remind of the student who is always in the front row of every class and asks (and answers) all of the questions. Were you that student in high school?

  • Norbert

    I run a few depots from 30 k … 500 k for relatives and close friends for many years already. I strictly follow KISS and 1/n approach with global stocks, REITs and AR/MFFs with altogether 6 up to 10 positions. I rebalance only when allocations deviate by more than 25% from targets. After giving my clients a very well reasoned intro to strategic asset allocation and my selection I never got any complaint but more and more requests for my help.

    • Ben

      KISS is one of my guiding principles. well said

      • mugabe

        Interestingly, a lot of purely technical analysts come to the same principle with regard to charts.

  • ratiocination

    As the owner of an RIA, I have been starting my day with Wealth of Common Sense for years, and have yet to find anything to disagree with. It is truly a wealth of common sense and good judgement, written clearly and succinctly. I’ve forwarded a number of them to clients. Thank you, Ben.

    • Ben

      Thanks very much. I appreciate that

    • mugabe

      Completely agree. It’s a fantastic blog to anchor yourself psychologically with regard to investing – written by someone who’s obviously reflected, and continues to reflect, a lot about the subject.

  • mugabe

    I’m not a financial advisor, but I would have thought that showing the historic ups and *downs* of the model you’re proposing, and asking the client questions to see how they would act, is key to psychologically screening them e.g. ‘So, you were down 20% in 1988. Are you going to stick with the plan?’, etc.

    • Flying Robot

      I think that’s a good start. I’d also suggest that the reality of impending doom, with newspaper headlines screaming disaster, is a lot tougher to deal with psychologically than a hypothetical 20% drawdown. That’s why understanding the philosophy is so important; it can give you that extra bit of gumption to hold your cards when everyone is panicking. Even those committed to a plan often fail to stay the course when they are caught in the emotions of the moment. In many ways it’s about each investor. Also, setting risk levels becomes more important as you get closer to retirement, because now you also have to think about sequence of returns risk etc… in other words, additional factors become prominent.

  • mugabe

    ‘Asset allocation is for long-term people.’
    This is the nub of the psychological problem.

    • Ben

      Yup simple not easy

  • Great article on Asset Allocation. I have been reading your blog occasionally for 2 years now, and I can still find points of view I can learn from.

    Keep up, thanks!

    • Ben

      I appreciate that. Thanks ver much for reading.

      • No problem. I also sent you an e-mail today. Please get back to me once you have the chance. Appreciate ya!