By Claudia Eardley
Have you ever heard the saying you shouldn’t put all your eggs in one basket? Based on the saying, if the basket were to fall – dropped, lost, stolen, etc – you’d lose all your eggs. This word to the wise is a warning against keeping everything that’s important to you in one place.
The Bible touches on this same theme. Ecclesiastes 11:2 emphasizes, “invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” We are told to prepare for what has not yet come but what can be expected.
In the investing world, asset allocation is just one example of a real-world application of this saying. To simplify the idea, good asset allocation makes sure you’re not investing all your money into just one investment. For example, imagine you invested all your money in Enron in 2000…ouch!
A portfolio can be compared to one big list of any holdings, stock or cash equivalents, an investor may obtain. Within a portfolio, assets can be managed in many different ways to increase diversification. Asset allocation is the financially literate term to explain the distribution of an investor’s holdings within their portfolio.
Market volatility is one of the main reasons why allocation is so important. Even if a stock or holding is screened and analyzed, at the end of the day, no one can predict the future of the market. Therefore, to avoid all your money being affected by one holding, it is better to have it spread out, or allocated, in a manner that is fitting for your risk tolerance, goals, wealth and mindset.
The great thing about asset allocation is there are so many different ways in which it can be executed. A few examples of how portfolios can be allocated are based on sectors, risk tolerance, and company size.
Diversification in sectors allows for economic fluctuation. Different types of sectors include industrials, technology, consumer goods, and health care (just to name a few). Ideally, industry sectors would all be able to withstand economic disruption, but that is usually not the case, hence the importance of sector differentiation.
Different sectors react differently to the economy. Tech is sensitive to changes within the industry, making it more volatile. Financials are influenced by interest rates, credit cycles and regulatory reforms. Healthcare is impacted by FDA approvals, policy changes, and demographic trends. Consumer discretionary is affected by spending patterns, and consumer confidence levels. The industrials sector is sensitive to global trade dynamics, capital spending cycles, and macroeconomic indicators.
Every sector is impacted in a different way which makes diversification important. It allows economic impacts to be spread out so if economic growth is lacking in one sector, another sector can carry your portfolio through that specific downturn.
A person’s risk tolerance can help determine how to allocate their portfolio. Risk tolerance can be different for every person. It is based on how comfortable someone is in the market, what they are willing to try, and how much they have to invest. There is a spectrum of risk from conservative to aggressive, and there are pros and cons to each approach.
For someone wanting more of a conservative approach, they’re going to be advised to have bonds as a strong player in their allocation as opposed to an aggressive approach that would hold a higher percentage of their portfolio in stocks rather than bonds.
The reason bonds would be considered more conservative is because they are less volatile, they typically have fixed interest income payments, and, in the case of a company going bankrupt, they have priority over stockholders.
Something to consider when assessing risk tolerance is the different return profiles. With a riskier allocation, or a more aggressive plan, the risk will be higher as stocks are more volatile than bonds; however, because of the risk, the investor is more likely to receive a high initial return or higher gain on a stock. With a more conservative approach, there is less risk; however, there is typically a lower rate of return as well. This offers a more stable return – just at a slower pace and not as high of a magnitude of increase within the portfolio.
Splitting an allocation between large and small companies is also a strategy used in some portfolios. This technique, known as market-cap weighing, is used since different sized businesses react differently to the market. In an expansionary economy, smaller businesses will likely thrive, while in an economic downturn, larger cap stocks will likely be more consistent. Due to these factors, small cap stocks are inherently riskier with a greater potential for return in comparison to a large, more established company.
By combining these methods of allocation, a well-balanced portfolio can be created. This creates an individualized plan for each investor while also taking into consideration the current state of the economy. Good asset allocation plans for economic inconsistency and a balance that should produce better and less volatile returns in the long run.
If you’d like professional help investing in a fully asset allocated portfolio, give us a call. For over 25 years we’ve help investors like you invest for the long-term and do it in a way that reflects their faith values.
Claudia Eardley is a 2024 summer intern at Beacon Wealth Consultants. Claudia is a sophomore at Liberty University majoring in Financial Planning, Finance, and Economics.