Many investors make decisions about investments, taxes, estate planning, future cash flow needs and future goals separately, as though each decision is distinct and won’t affect the others. This can lead to suboptimal outcomes for families. At Exencial, we believe all aspects of an investor’s financial life are interconnected and should be integrated into a cohesive strategy.
One of the last steps in integrating these financial decisions is asset allocation1, a strategy that determines how you will invest in order to meet future goals and cash flow demands. For example, you may want to retire early, save for your children’s college education or set aside money for charitable giving. These future cash outflows need to be met with cash inflows from investment assets, which is where asset allocation comes into play. When done properly, studies conducted by Vanguard2 and Morningstar3 have found that improving asset allocation decisions should improve returns and asset accumulation over time.
There are three primary investment asset classes we consider when building an asset allocation strategy.
1. Fixed income/preservation: This group includes money market deposits, bank certificates of deposit (CDs), Treasury bonds, corporate bonds and other various forms of debt that generate some amount of fixed income. These assets tend to be more stable and are accompanied by more muted price movements. However, this also makes for smaller returns over time compared to other asset classes.4 Fixed income investments often do not offer high enough returns to meet investors’ goals, which places a limit on the amount of assets we can allocate to this category.
2. Real assets/equity income investments: These are investments that give exposure to real assets5 or have a component of inflation embedded in expected returns (e.g., real estate, commodities, etc.), or those that behave like a combination of equities and fixed income (e.g., preferred stocks6, convertible bonds7 and master-limited partnerships or MLPs8). The expected returns for this asset class fall somewhere between those of equities and fixed income. Many investors are often drawn to equity income investments that offer 4 to 10 percent in annual income, but we recommend avoiding being too heavily invested here as this is a smaller area within the capital markets.
3. Equities/growth: This asset class includes U.S. publicly traded stocks, international and emerging market publicly traded stocks and private equity. While these investments often provide much higher returns than fixed income, they are also more volatile and involve greater risk.9 For investors who require income from their assets, it may not make sense to have an all-equity asset allocation. We see an average of three to four 5 percent pullbacks each year10 and do not want to be forced to sell assets trading at low prices because investments are concentrated solely in the equity market.
Based on each investor’s goals and planning considerations, there should be ranges of acceptable allocations to each asset class. Depending on an investor’s individual preferences, these ranges can then be narrowed to a specific weight.
For example, some people are more conservative by nature and may prefer to be at the higher end of the range within the fixed income/preservation category.Others are natural risk-takers and may want to be at the higher end of the equity allocation range.
We work with our clients to develop an asset allocation strategy that aligns with their financial planning needs and incorporates their preferences. If you have any questions about your current asset allocation, please contact your Exencial advisor.
1. Investopedia – Asset allocation
2. Vanguard – Putting a value on your value: Quantifying Vanguard advisor’s alpha
3. Morningstar – Alpha, beta, and now…gamma
4. Investopedia – Fixed income
5. Investopedia – Real asset
6. Investopedia – Preferred stock
7. Investopedia – Convertible bond
8. Investopedia – Master limited partnership – MLP
9. Investopedia – Equity
10. CNBC.com – Grading the market: A routine pullback or has the trade war damned the S&P 500 to a trading range?
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