Asset allocation is one of the most important decisions that an investor will make for their financial future.
If financial freedom is one of your goals (and let’s be honest, who doesn’t have that as a goal?), then you’re going to want to make sure your money is working for you. Investing in the right mix of stocks, bonds, cash, real estate and other asset classes, will ensure that you are set up to reach your goals.
But if you’re just new to investing, it is understandable if it all sounds a bit like a foreign language.
But, in this blog, you will learn:
- What is asset allocation, and why it is important.
- Why the majority of investors get this wrong, and what to do to make sure you don’t.
- How 3 simple buckets can change your life.
Let’s start by taking the complicated and sophisticated concept of “Asset Allocation” and making it simple and easy to understand. Once we have addressed that we will take a look at why the majority of investors fail to get this right, and what you can do to ensure you don’t.
Ok, let’s get into it. What is Asset Allocation?
Essentially, asset allocation is the way you split up your resources. Simply where you decide to invest your time and money amongst asset classes like stocks, bonds, cash, real estate. The trick is allocating your assets in such a way that brings you the maximum reward with the minimum amount of risk.
Getting the best bang for your buck, with the least chance of losing it.
It also assures that you reduce risk through diversification, protecting your portfolio from sudden changes in the market. To diversify means variety, so not putting all your eggs in one basket (or bucket in this case). If all your eggs are in one basket, and the basket breaks or spills, then you risk losing all your eggs.
Don’t put all your eggs in one basket
Historically, conditions that lead to one asset class outperforming during a given timeframe might cause another to underperform. Diversification, by investing in both asset classes, results in less volatility (or movement up and down in value) for investors on a portfolio level since these movements offset each other.
Asset allocation is the first thing you should consider when getting ready to purchase investments, because it has the biggest effect on the way your portfolio will perform.
The majority of investors think it is the selection of specific investments (such as stocks) and being able to correctly time the market (when you buy and sell, that makes them money. Yet, according to Vanguard, asset allocation accounts for a whopping 88 percent of your portfolio volatility and the returns you earn.
This means, your experience will be very consistent with that of any other diversified investor with the same asset allocation, regardless of the specific investments you choose.
In other words, asset allocation matters a lot more than selecting the right stocks or being able to time the market when it comes to reaching your financial goals!
The way I like to consider my own asset allocation, is to use the following 3-bucket analogy.
There are three buckets to asset allocation. Your
- Safe & Secure Bucket,
- Growth Bucket,
- Dream Bucket.
Let’s take a look at the different purpose of each of these buckets and how they offer different options, and how each benefit you.
THE SAFE AND SECURE BUCKET
The first bucket is your Security, or Peace of Mind, Bucket. This bucket will give you certainty in your life. This bucket represents the tortoise mentality – slow and steady wins the race. Except in this case, winning the race means not losing your life savings. If the safe and secure bucket was a car, it would be a Hyundai. It’s not sexy, far from cool, but its economical, and reliable. It will get you where you need to go safely, with none of the whiz bang extras that flashier cars have.
Essentially, your Safe & Secure Bucket is where you want to keep the part of your nest egg you can’t afford to lose. It’s a sanctuary of safe investments that you lock up tight – and then hide the key. In monopoly, I called this my secret savings. My contingency fund, my grandmother called it the rainy-day fund.
How do you fill your Safe & Secure Bucket?
So, what kind of investments would you find in – or allocate to – your Safe & Secure Bucket?
You want investment options with low volatility. Options such as:
- Cash/Cash Equivalents (such as money market funds with checking privilege)
- Your Superannuation
- Your home –This is your sacred sanctuary, and as such should be treated completely different than any investment properties. You shouldn’t be “spending” it!
- Your life insurance policy.
These grow slowly, especially at first, but the power of compounding means you can find safe investments with maximum rewards in a secure environment.
THE GROWTH BUCKET
The Growth Bucket is where you take risks, to achieve growth. It is very sexy and exciting because you can gain some truly amazing returns here. It’s that high end sports car that is thrilling and fun, put the top down, and let the wind blow through your hair and feel alive – it’s beautiful and fast, but you might also end up on the side of the road wondering what went wrong. Because, although you can be rewarded for your risk in these investments, you can also lose everything you’ve saved and invested.
How do you fill your Growth Bucket?
Whatever you put in your Growth Bucket; you have to be prepared to lose it – especially if you don’t have protective measures in place.
Here’s a sampling of seven main asset classes to consider:
- Equities – another word for stocks, or ownership shares of individual companies or vehicles for owning many of them at once, like mutual funds, indexes, and exchange-traded funds (ETFs).
- High-Yield Bonds (aka junk bonds)
- Real Estate
- Commodities (gold, silver, oil, coffee, cotton, etc)
- Collectibles – like fine art
- Structured Notes (anything without 100% principal protection).
THE DREAM BUCKET
The previous two buckets were all about accumulating wealth, this bucket is for accumulating the memories. The purpose of the Dream Bucket is to have fun, setting aside something for yourself and those you love so that all of you can enjoy life. The idea of this bucket is to reward yourself, the purpose is to excite you, to put some juice in your life so you want to earn and contribute to your wealth accumulating buckets even more. Think of the items you’re saving for in your Dream Bucket as strategic splurges. It’s the personal rewards.
Be creative! What can you not stop dreaming about? What makes you want to cry when you visualize yourself achieving it? It could be season tickets to your favourite sports team, show, or theatre. That sports car – maybe one that isn’t so practical, but feels great. It could be handing over the keys to a new home to your parents and treasuring the look on their faces. Perhaps you travel a lot and dream of upgrading from Economy to Business Class? That holiday with loved ones.
Your imagination is the limit.
Many people have a lot of money but not much lifestyle. They spend their lives watching numbers accumulate in a bank account and miss out on the joy along the way. That’s what the other two buckets are for, this bucket is for the memories, not the numbers. Your dreams are not designed to give you a financial payoff; they are designed to give you a greater quality of life.
How do you fill your Dream Bucket?
There are three ways in which you can fill this bucket.
- Wins – If you get a bonus or a windfall above and beyond what you had expected, you may want to allocate some of that to your dream bucket.
- Your Growth Bucket gets a positive hit and you score big. In this case, you may want to take some of the risk off the table and put one-third of the unexpected returns into each bucket.
- Save a percentage of your income and allocate it to your Dream Bucket.
SO HOW MUCH GOES IN EACH BUCKET?
It depends on how much time you’ve got to grow your investments and how much risk you’re willing to take. Before you choose, consider these three factors:
- Your stage in life
- Your risk tolerance and
- Your available liquidity (available cash).
You’ve got to ask yourself, “How much risk can I afford to take at my stage in life?” But remember, you’re not diversifying just to protect yourself. You want to enhance your results to find the ideal blend of investments that will allow you to thrive, not just survive!
Ask yourself, “Before I invest, is this putting me at risk? Is this something I’d be better off having in my Growth Bucket or in my Safe & Secure Bucket?”
It’s important here to really put some time and effort into creating a set of rules for yourself based upon the above information, on what goes where, and stick to it.
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For me, my Safe & Secure Bucket is set up to cover my costs of living for one year. Then if for whatever reason, I find myself without an income, I have 12 months to change that.
My Safe & Secure Bucket is also intended to underpin my basic living costs in retirement. To make sure that happens, I need to ensure that by the time I retire the return on investments in my Safe & Secure Bucke will cover my cost of living every year from then on. Here’s where inflation, interest rates, and compound interest play a major role.
I set up a rule where anything over and above a certain level from my second bucket, the Growth Bucket, automatically goes into my Safe & Secure Bucket. Once those two buckets have reached where I had wanted them to be, at that period of time, then the Dream Bucket gets fed.
This is how it works for me, each and every person is different, and I encourage you to come up with a plan that best suits you. There is no single solution for allocating your assets. Individual investors require individual solutions. As well, asset allocation is not a one-time event, it’s a life-long process of progression and fine-tuning.
DON’T FORGET TO DIVERSIFY!
Don’t just diversify between your buckets, but be sure to diversify within them as well. Spreading your money across different investments decreases your risk and increases your upside returns over time.
You’ve just made the most important investment decision of your life. And once you know what your percentage is that you allocate to each bucket, you don’t want to alter it until you enter a new stage of life, or your circumstances change dramatically. You’ve got to stick with it and keep your portfolio in balance.
Depending on your personality, it can be easy to get caught up in great returns and forget how much you are risking in the process. Ultimately, it’s the right mix at the right time that brings you success and financial security.
Other blogs you might be interested in:
What’s in your Dream Bucket?
Note: The information in this article is general in nature as it has been prepared without taking account of your objectives, financial situation or needs.