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March 10, 2022 — 12 min read

Asset allocation and how to use it to reach your financial goals

Josh Pigford

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Josh Pigford

In simple terms, asset allocation is defined as dividing your portfolio among the different investment categories available such as stocks, bonds, real estate, gold, crypto, cash, etc. By understanding the concepts behind asset allocation, you will understand the right mix of assets you need to invest in to achieve success in both your short-term and long-term goals.

What is an asset class?

To understand asset allocation, we have to wrap our heads around what an asset class is. In simple terms, an asset class is a group of investments with certain common characteristics that behave similarly to each other.

Consider the different tech products you use in your day-to-day life, like your mobile phone, laptop, television , and so on. Even though you can watch your favorite Netflix show on all of these devices, each device has its individuality and serves a different purpose.

This variability is the same in terms of asset classes. Even though you can use several asset classes for wealth building and preservation, each asset class serves its purpose and is irreplaceable in its own right.

What are the different types of asset classes?

Throughout recent history, there have been five major types of assets classes. They are:

Types of Asset Classes.png

Next, let's take a quick look into each asset class and how it can help you achieve your financial goals.

Which asset class has given the best historical returns?

Even though new asset classes like cryptocurrencies have given some spectacular returns in the last few years, the big five asset classes have all been around much longer than that. Looking at performance over long timeframes (100+ years), the stock market has produced the highest returns over time.

If we start our journey of investing in the early 1920s, the CAGR (compounded annual growth rate) of the S&P 500 has been about 7.68%, assuming all dividends are reinvested and adjusting for inflation.

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To put it in monetary terms, $100 invested in the S&P 500 on January 1, 1920 , would have been worth about $185,900 (in 1920 dollars, adjusted for inflation) by February 21, 2022. In 2022 dollars, that’s $2.614 million without adjusting for inflation. In comparison, the same $100 invested in T-Bills , a money market instrument, during the same period would have returned little more than $8000 in today's dollars. You can check out all the above calculations and enter your inputs here.

Stocks can be high ly volatile in the short term, and the key is giving it time to run by overcoming the urge to sell during short-term volatile periods. The S&P 500, for example, is far less reliable over any 12-month period, meaning you face a greater risk of losing money.

However, when you stretch the holding period to five years, you're far more likely to make money. So, the longer your holding period is, the more likely you will make money in the stock market.

Investments performance succeeding cr...

Why are asset classes useful?

Asset classes can help you diversify your investment portfolio to maximize your returns based on factors like your tolerance for risk, financial goals, investment objectives, investment time horizon, and preferences towards certain types of assets.

Investing in different asset classes enables you to ensure a certain diversity in your investments as each asset class has different characteristics and behaves differently in any given market environment.

How to allocate assets to meet your financial goals:

Now that you know about the different asset classes and how you can leverage them to achieve your financial goals, we can start thinking about allocating your investments across various asset classes.

The answer to the question of how to allocate assets is the dreaded phrase: "It depends.". However, we can look at some of the factors you must consider when deciding how much of your portfolio you can dedicate to each asset class.

Some of the factors you have to take into consideration while allocating your assets are:

Improvements in asset allocation:

Now that we've learned about the different assets and how to use them in our financial portfolio based on certain factors, we can discuss how you can optimize your allocation from financial and personal perspectives.

Global Diversification: Diversifying across different markets all across the globe can be an effective way to improve returns and reduce volatility. You can use the famous phrase: "Every day there is a bull market somewhere in the world." to your benefit. Getting exposure to global equities reduces the impact of localized downturns in certain markets and diversifies your investment across different geographies.

The table below shows that no single market has consistently outperformed any other over the past ten years. Also, diversifying globally has the added advantage of reducing volatility which keeps you invested in the market even during economic downturns. You can start by investing in a global ETF like the Vanguard Total International Stock Index Fund ETF ($VXUS).

Annual performance of asset classes b...

Small cap vs large cap - Performace o...

Nowadays, there is a much more comprehensive array of asset classes from which you can pick and choose, like artwork and NFTs, collectibles, financial derivatives, and so on. If you have the appetite for it, you can choose to allocate a small portion of your portfolio to these asset classes as well.

Final Thoughts and wrap-up:

We've come a long way in this post, from understanding the concept of what an asset class is, to learning about the different asset classes and how to allocate them efficiently based on certain factors to reach your financial goals. Finally, we learned how to optimize and improve your asset allocation.

Even though we've covered so much, it’s important to remember that the asset allocation you choose will depend on your personal preferences and environment. The asset allocation you want to pursue is dependent on your goals and risk tolerance, so it would be advisable to build out the assets in your portfolio based on your particular situation. A simple rule of thumb: allocate your assets so that it helps you sleep well at night.

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