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Guest Blog: The Importance of Asset Allocation ⚖️

March 1, 2022

Guest post by Dr. Barbara O’Neill, CFP®, AFC®

 

403(b) plans — and 457(b) and 401(k) plans — involve four separate decisions:

  1. Whether (or not) to open an account and voluntarily make pre-tax contributions
  2. What amount, typically a percentage of pay, to save
  3. What vendor to select from among employer-provided options
  4. What type of investments to select from the chosen vendor

Smart 403(b) plan participants select investments using asset allocation, the process of diversifying among different categories of securities called asset classes. Plan contributions are divided proportionately according to asset class weights. For example, 50% stock, 30% bonds, 10% real estate investments, and 10% cash equivalent assets (e.g., money market funds and certificates of deposit).

This post describes a six-step asset allocation process, asset class components, factors to consider when developing an asset allocation strategy, portfolio rebalancing, “need to knows” and research findings about asset allocation, and six take-away action steps.

Why Asset Allocation?

Asset allocation helps reduce volatility (i.e., sharp investment price changes). Investors hope gains in one asset class will offset losses in another. Since nobody knows in advance how investments will perform, asset allocation “hedges bets.” The trade-off: diversification generates a lower return compared to a “hot” asset class. Instead, it provides reasonable returns with less volatility and works best over time.

Stock, bonds, and cash equivalents are three “core” asset classes and each one serves a purpose beyond diversification. Stocks provide growth potential for wealth accumulation; bonds, an income stream; and cash equivalents, liquidity and stable value.

Key Factors

There is no “one size fits all” asset allocation. Instead, there are four key factors to consider:

  • Age — Typically, young investors have a higher stock percentage in their asset allocation than retirees. They have decades to grow their money for retirement and ride out periodic market downturns.
  • Risk Tolerance — Conservative investors elect less stock to reduce volatility and investment-related stress. This University of Missouri assessment tool is a good measure of investment risk tolerance.
  • Investment Experience — New investors may increase their stock percentage after investing for a while and better understanding how investments work.
  • Available Resources — Investors who have accumulated significant sums or have a pension for guaranteed retirement income may elect a higher stock percentage.

Asset Allocation Formula

There is one more factor to consider: a math formula. It is just a guideline, however, and not “one size fits all.” As noted above, age is not the only asset allocation variable.

Conservative Investors: Subtract 100 minus your age for the asset allocation percentage in stock. For example, at age 40, 100 – 40 = 60%.

More Aggressive Investors: Subtract 110 minus your age for the stock percentage. For example, at age 40, 110 – 40 = 70%.

Some experts suggest other formulas, such as 115 or 120 – age for those with a very high risk tolerance.

Six Steps

Are you still wondering how to create a personal asset allocation strategy? Follow this six-step process:

  1. Determine your time horizon until retirement (e.g., 25 years)
  2. Determine your investment risk tolerance
  3. Calculate the asset class mix of your current portfolio
  4. Determine your preferred asset class mix based on factors noted above
  5. Reallocate current investments or invest new money to reach the proper weighting of asset classes
  6. Review and rebalance your portfolio regularly

Portfolio Rebalancing

Once you develop a target asset allocation, remember to periodically review asset class percentages and  rebalance your 403(b) plan portfolio, when necessary. Asset weight percentages shift over time due to market fluctuations. Your plan provider may provide asset class weights or you can use a spreadsheet.

Rebalancing means returning to your original asset class weightings by either selling securities in an over-weighted asset class (e.g., stock) or putting new deposits into an under-weighted asset class (e.g., bonds). When rebalancing is done within a tax-deferred 403(b) account, security sales are not a taxable event.

Some 403(b) vendors offer portfolio rebalancing as an optional client service so plan participants can conveniently maintain their asset allocation weights. Typically, they rebalance on a regular basis (e.g., on a designated date, such as a birthday). Rebalancing services can also be suspended later, if desired.

Research Results

Research, including a classic study from 1986, has shown that asset allocation is a major factor affecting portfolio performance.  It is not what specific stock or bond that people invest in that matters the most over time, but, rather, that they have money placed in different asset classes. Many other studies of determinants of investment performance have also been conducted, some with similar results.

Three (More) Things

  • Consider asset location as well as allocation. This is the use of different types of investment accounts: tax-deferred (e.g., 403(b)s), tax-free (e.g., municipal bonds), and/or taxable (non-retirement accounts). The goal is to achieve tax diversification/efficiency since these accounts are taxed in different ways.
  • Each year, Callan Associates updates a colorful chart, akin to a patchwork quilt, that shows asset class performance during the past 20 years. The best performing asset class typically changes from year to year.  One year’s winning asset class can be next year’s loser. That is why diversification reduces risk.
  • For older adults who have saved/invested for decades and accumulated large sums, rebalancing can be tricky. It requires reallocating (e.g., stock fund to bond fund) or depositing larger amounts of new money to maintain asset target weights. Transfers within a 403 (b) account avoid immediate taxation.

Six Smart Strategies

No. 1: Diversify Within Asset Classes — Investments within major asset classes include large, medium, and small company growth and value stocks; foreign stocks from developed and developing (a.k.a., emerging markets) countries; domestic and international bonds; real estate-related investments; and various types of cash equivalent assets.

No. 2: Watch Your Stock Exposure — When the stock market does well over time, stock weightings in a portfolio can rise beyond an investor’s target asset allocation and comfort level (e.g. from 50% to 65%). The Wall Street Journal recently noted than many older adults have too much stock exposure and need to “skim profits from their winners.”

No. 3: Don’t Panic and Market Time — While investors often tweak their target asset allocation weights every decade or so, as they get older, they should, otherwise, stick to a strategy. Trying to “time the market” (i.e., buying and selling securities according to market highs and lows) is generally futile and will undermine an asset allocation plan.

No. 4: Consider a Target Date Fund (TDF) — DFs are mutual funds with a future date in their title (e.g., “Retirement 2050 Fund”). They are sold in five or ten year increments to match investors’ planned retirement date. TDFs select an asset allocation for the target date and automatically adjust it to a more conservative mix as shareholders get older.

No. 5: Focus on What You Can Control — Nobody can control market performance or the return of different asset classes. What they can control is fees paid to open and maintain an investment account. Look for a 403(b) plan vendor with low expenses; e.g., mutual funds with a low expense ratio (i.e., percentage of assets charged for operating expenses).

No. 6: Seek Out Resources — An online search of the words “asset allocation calculator” will provide a number of online tools that ask questions about age, current assets, annual savings, marginal tax rate, expected returns, and risk tolerance level. Try at least three calculators to determine appropriate asset allocation weights.

In Summary

Asset allocation results in a weighted average of portfolio asset classes. As a simple example, if 60% of the portfolio is in stock, 30% in bonds, and 10% in cash equivalents, and the three asset classes earn 8%, 5%, and 2%, respectively, the weighted average return would be 6.5% (.06 x 8% = 4.8 + .03 x 5 = 1.5  + .01 x 2 = .2).

Take the time to determine a good asset allocation mix for your 403(b) and other investments.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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