Night School: Asset Allocation

night school handout open on a desk

What Is It?
Asset allocation is the mix of different types of investments in a portfolio. It provides risk reduction through diversification and requires initial and ongoing decisions based on an investor’s goals, circumstances, and changing market conditions. It’s the “don’t put all your eggs in one basket” approach to investing.
Asset Allocation at Its Most Basic
A common mix has stocks (equity ownership in a company), bonds (debt securities issued by governments and companies), and cash (such as interest-bearing money market funds).
Stocks (also called equities) have provided growth in market value (capital appreciation) over time; they also often generate current income from cash dividends paid to shareholders.
Stocks come in various sizes: large, mid, and small, based on “market capitalization,” which equals a company’s stock price times the total number of shares outstanding. Apple’s market cap, for example, is about $900 billion; Century Bancorp, one of our favorite stocks, has a market cap of $300 million.
At Clean Yield, we invest in stocks of all sizes, with a tendency toward mid- and small-caps, as we search for undiscovered bargains.
Bonds (also called fixed income) are usually bought for current income and portfolio stability rather than capital appreciation. A bond typically provides fixed interest payments until it comes due (matures) on its maturity date. Bonds are initially sold at “face value” (100 cents on the dollar), trade on the bond market, and mature at face value.
A bond’s price (market value) fluctuates (due mainly to the level of prevailing interest rates) until it matures. For example, an existing bond that pays 4% annually becomes more attractive if the prevailing rate of interest falls significantly. Other investors will buy the 4% bond rather than a new, lower-yielding bond, which drives up the price of the 4% bond until its effective yield (on the higher price) is equivalent to a new, lower-yielding bond. This works in reverse as well; in a period of rising rates, existing bonds become less attractive and fall in value because new bonds offer higher yields.
A bond mutual fund owns (and trades) dozens or hundreds of individual bonds. Though each individual bond behaves as described above, the overall bond fund does not mature.
We at Clean Yield buy individual bonds that mature in a relatively short time (usually 2-5 years), which reduces market fluctuations and ensures maturity at face value.
Cash (often in the form of money market funds) is used to take advantage of new investment opportunities and provide some protection against large market declines.
The primary benefit of a diversified mix of investments is to reduce the overall volatility of the portfolio’s value via investments that tend not to move in sync through various economic and market cycles.
Additional Sources of Diversification
Real estate investment trusts (REITs) are real estate companies whose shares are traded on stock exchanges.
American Depository Receipts (ADRs) allow U.S. investors a convenient way to invest in foreign stocks without having to convert to foreign currencies and trade on foreign exchanges. ADRs represent ownership in foreign companies but are priced in dollars and traded on U.S. stock exchanges. (Their prices and dividends are still affected by swings in foreign exchange rates.)
At Clean Yield, “impact investments” are broken into two categories: community investments and alternative investments, which have little to do with the performance of the stock market. Community investments are promissory notes issued by nonprofit lending institutions (e.g., Vermont Community Loan Fund and Calvert Foundation) that generally have robust loan loss reserves that protect investors. In times of stock volatility, these intermediate-term investments (2-5 years, most often) don’t change in value, providing stability to portfolios that include them. Alternative investments take a variety of forms but generally have longer holding periods and higher risk. They include private equity funds and direct investments in individual companies. Because these securities are not publicly traded and are long-term in nature, they are also less subject to the vagaries of the stock market.
Portfolio Asset Allocation Ranges
With various investment types available, how should an investor decide which ones to invest in and in what proportions?
It depends on one’s financial goals and risk tolerance. That includes financial and emotional ability to absorb large losses, as well as one’s income needs, investment time frame, and tax situation.
Asset allocation ranges are often based largely on one’s age. A younger investor typically takes more risk by favoring stocks because of an ability to wait many years to recover from market declines. An older investor tends to take less risk by favoring bonds to reduce portfolio fluctuations and produce investment income in the absence of employment income.
At Clean Yield, we develop customized investment policies for our clients that reflect their specific financial goals, risk tolerance, income needs, and social values. These policies include ranges for each asset class, which allow for adjustments based on market conditions and valuations. For example, a portfolio may have a range of 50-70% in stocks, 20-40% in fixed income, 5-10% in impact investments, and up to 15% in cash. When stocks look cheap, we may increase the stock weighting toward the 70% level and lower cash holdings. The reverse may be true when stocks look expensive and their prospects are subpar. At that point, we will scale back stock holdings toward the low end of the range. (All such changes may be affected by each client’s tax situation, which may constrain portfolio activity.)
The bottom line is diversification matters and choosing the right mix of assets, not just the right stocks, can materially impact performance. Dividing those eggs between baskets can make all the difference.