When it comes to asset allocation, most of us only think about our obvious financial investments, like our pensions and ISAs. But the reality is that our overall financial picture often includes a much wider set of assets than that. In this article we explain the right way to assess and plan your personal asset allocation so that you’re taking the right level of risk for your goals.
When you’re sitting at home on a Saturday night calculating your net worth, as we all do, would you leave your main residence out of the calculation? What about the company shares you’ve received as part of your employment package?
Of course you wouldn’t. Now while sitting at home on a Saturday night with a net worth spreadsheet might not be something you (or any sane person) actually does, something that is common is leaving out a large portion of their assets when reviewing their asset allocation.
Have we lost you at asset allocation? Don’t worry, in this article we’re going to explain why asset allocation is something you should be paying more attention to, and why most investors (and even some money managers) look at it in totally the wrong way.
Before we get into the rights and wrongs of asset allocation, let's explain exactly what it is. Asset allocation is the term used to describe the way your assets are split between different types of assets. It’s often expressed as a pie chart, and common asset classes include:
Stocks and shares
Alternatives (from classic cars to hedge funds, artwork to angel investments. You name it, there’s probably a way to invest in it.)
It mainly comes up when talking about financial assets, like a pension pot or an investment fund. That’s a problem, but we’ll get into the details of that in a bit. Asset allocation is also the way that financial portfolios are assessed for risk.
The higher the percentage of a portfolio that’s allocated to growth assets like stocks, the higher the expected volatility and the higher the expected long term returns.
And while asset allocation is a really useful part of the investment process, in many cases there’s a massive blind spot when looking at it.
That blind spot is ignoring a large portion of your assets. As we mentioned earlier, we come across many people who only look at specific financial assets when considering their asset allocation.
Here’s a common scenario. Jess has an ISA, pension and a general investment account worth a total of £450,000. She considers herself a high risk investor, as she wants to maximise her potential for returns over the long term
Her current asset allocation in those accounts looks something like this:
Growth Assets 89%
US Stocks: 60%
UK & Europe Stocks: 18%
Emerging Market Stocks: 6%
Property Trusts: 2%
Defensive Assets 11%
Fixed Income and Bonds: 6%
Jess is pretty happy with this. Overall there's 89% in defensive assets and 11% in growth assets, which she feels is a good balance for her risk profile and should provide her with sizeable returns over the long term.
But here’s the problem. Jess works at a US tech company, and a significant part of her compensation comes in the form of stock options, which vest over time. She’s not been at her current company all that long, but so far she has £30,000 in vested stock.
As well as that, she owns a 2 bedroom flat. There’s a mortgage on it, but Jess’ equity in the property is worth about £180,000.
So when looking at her asset allocation, Jess is ignoring a huge component of her overall assets.
In many cases we’ll see those two assets get completely ignored when it comes to Jess’ overall asset allocation. But they’re just as important in assessing her overall level of risk as the traditional financial assets in her investment accounts.
When we add her home equity and her £30,000 in stock holdings to her other assets, the asset allocation picture looks quite different.
Growth Assets 68%
US Stocks: 50%%
UK & Europe Stocks: 11%
Emerging Market Stocks: 4%
Property Trusts: 1%
Defensive Assets 32%
Fixed Income and Bonds: 4%
Home Equity: 25%
So when we take into account all of Jess’ assets, her real asset allocation is actually 68% in growth assets and 32 % in defensive assets. That’s significantly less risk than Jess is taking in just her main financial portfolio.
So when it comes to the right way to calculate your asset allocation, it’s vital that you take into account all your assets. It’s important for a couple of different reasons:
As mentioned above, by adding all your assets to your portfolio pie, you’re going to get a warped idea of the risk you’re taking. Maybe you’ll be taking too much risk, which could mean you’re in for a nasty shock when markets fall.
Or it could also be a problem in the other direction, perhaps you have a large amount of cash, which means that your overall asset allocation isn’t risky enough. That could mean your long term returns are underwhelming, and you might have to work for years longer than you’d planned.
No one wants that.
As well as the importance of keeping an eye on your overall asset allocation, you’ve also got to watch how much you’ve got in each asset class. Property is a really common example that we see.
Some of our clients have equity in their main residence, plus a buy-to-let, meaning that they’re already really overweight towards property. If the property market goes through a rocky period, it means that they’re going to really feel the brunt.
In that case, you probably shouldn’t make that issue worse by having a major allocation to property within your ISA or pension.
Same with stocks. Jess has £30,000 in direct US stock from her company. Ignoring the fact that all that money in a single stock is a big risk by itself, she should really adjust the weight in the rest of her portfolio to make sure she’s not too heavy into the US market or tech sector.
But proper asset allocation doesn’t end there. Another factor that is super important is the level of liquidity within a portfolio. After all, it’s all well and good to have your funds well diversified, but if you can’t get access to them they’re not going to be of much use.
If you’re not familiar with the term, liquidity is the term used to describe how easy it is to turn an asset into cash. Cash itself is as liquid as it comes, because it’s, well, already cash.
Widely traded stocks in large companies are highly liquid, because you can sell them at any time and have the cash in your account in a couple of days. Assets like physical property or privately held companies are very illiquid.
Sometimes it may not even be possible to find a buyer, and if you do it can take months to complete the sale.
This is a hugely overlooked component of asset allocation, and there are a couple of major issues that can arise if your portfolio is too illiquid.
You might be a multimillionaire on paper, but if you can’t hold any of that in cash, your lifestyle isn’t going to reflect it. We come across this all the time with clients. Many of them have founded successful businesses with valuations stretching to 8 figures and beyond, but because they’re privately held, they can’t easily access any of that value.
That might not be a problem for a young founder with few financial commitments, but over time as they want to buy a home or raise a family (or just travel and enjoy better dining out), it can become an issue.
The second major problem is that it makes your asset allocation a much more fixed proposition. For our clients we recommend regular rebalancing to make sure that the portfolio matches their attitude to risk and their objectives.
To do that, you sell some assets and buy others.
But obviously if you’re got money tied up in assets that you can’t easily sell, you’re not going to be able to rebalance your overall asset base easily. It means that problems with your asset allocation might just get worse over time.
All of this is to say, there’s a lot that goes into getting your portfolio setup the right way. You could keep throwing darts at the board and hoping that it works out, or you could speak to the professionals.
We’re experts at making sure we find the right balance between creating a portfolio that gives you the opportunity to meet your financial goals, while being tailored to your own specific assets and circumstances.