Asset Allocation: Equity, Fixed Income & Cash – What are they and what role do each of them play in our portfolio. Read on to find out.
Let’s start by introducing a new term: Asset Class. In order to understand and manage our investment portfolio, it helps to break our investments down into categories. Asset Class is a way to do that. Equity, Fixed Income and Cash are the three asset classes we’ll discuss here.
Equity
If you read the post on stock, you’ll know that equity means ownership. Stocks are a good example of equity, because by purchasing a stock, we are buying a piece of a business. There are other types of equities as well. We could own rental properties, a coin collection, or exotic cars.
The value proposition for an equity investment is that we will buy it at a point in time, and at some point in time in the future, it will be worth more money and we can sell it for a profit. That profit is called a capital gain. It is the increase in value between the purchase date and the sale date. We could also have a capital loss if the investment loses value.
Equities are a key part of our portfolio. History has shown us that equities, as a group, but certainly not all equity investments, have the most potential for gain.
Stocks are a very common form of equity in our investment portfolios. Here are some facts to highlight the volatility, but also the potential of stocks:
- Historically, stock market corrections (a drop of 10% or more from the 52 week high) occur once every 2 years
- These pull-backs typically last about 6 months
- Of the 30+ corrections that have taken place in the last 40 years, each time, the stock market has gone on to reach a new high
- The S&P 500 (an index of the 50 largest US public companies) has averaged a roughly 9% annual return (with dividends re-invested) over that last 90 years.
Fixed Income
See the post on Bonds for more on Fixed Income, for now, it’s enough to know that fixed income refers to investments that have a fixed duration and a fixed interest payment. This includes corporate bonds, government bonds and certificates of deposit (CDs).
Unlike an equity investment where we are buying something of value, with the expectation that the value will be greater in the future, with a fixed income investment, we are giving money to the instrument issuer, and that issuer will make regular interest payments to us, for a specified period, at the end of which, the issuer will return our initial investment in full.
Bond Example
Let’s look at a simple example. We buy a Walmart 5% coupon bond with an expiration date of 1/30/2034. What did we buy and why? Most US corporate bonds have a face value (also known as par value) of $1,000. So in this case we bought a $1,000 Walmart bond, which essentially means we loaned Walmart $1,000.
We’re nice people, but we can’t just go throwing money around, even to Walmart, so there are some terms associated with this bond purchase. Walmart will pay us 5% (the coupon) per year, every year in interest. The interest payment could be made annually, semi-annually, or quarterly, but the total payment for the year will be 5%, or in our case $50. The expiration date of 1/30/2034 tells us that on that date, we will receive our $1,000 back and interest payments will cease.
So pretty cool, we loan out some money, we collect a fixed interest payment each year, and then we get our money back. Fixed income has some risk, the issuer could go bankrupt, federal reserve interest rate changes could impact the value of our bond, but all in all, it has generally been a less volatile asset class than equities, though it has historically grown in value more slowly than equities.
Cash
Also known as cash and cash equivalents, this tends to be the least volatile asset class. This is money that is in a bank account, a brokerage cash account, or a money market account. It is very unlikely that the value of these assets will go down, but there is the risk that the buying power could go down if the interest we make does not keep up with inflation.
Asset Allocation: How do we decide?
Now that we know the 3 key asset classes, we need to decide how to allocate the investments in our portfolio amongst the 3 asset classes. This is called asset allocation. At this point, I’d love to give you the magic formula that will make you wealthy, but the truth is this is a complex decision. Let’s talk about the factors that go into this decision.
Time
Our time horizon is a key factor in determining the appropriate asset allocation. Equities are likely to gain the most over time, but are the most volatile. We want to be sure that money we are going to need in the next 5 years is not in equities. We don’t want to be in a position where we need access to our money while the stock market is in an extended down period.
There is a common bit of investing advice that says we should determine our equity allocation by subtracting our age from 100. If we are 20 years old, we should have (100-20=80) 80% of our portfolio in equities. If we’re 60, we should have 40% in equities. Not a bad rule of thumb. Early on, we want to take advantage of that growth that equity offers and as we get closer to needing the money, we should have migrated some to cash and fixed income to avoid having to pull out equity investments during a down market.
Risk Tolerance – balancing your portfolio
That said, there are other factors in play. One is our tolerance for risk. I really dislike the risk tolerance question. It’s kind of like asking one of my friends if they like their wings spicy. The answer is always yes and often leads to a competition. Same with risk tolerance. Of course I can handle risk.
It’s a different story when the market is down 40%, some of my companies are down 80% and I’m retired.
Instead of risk tolerance, I think more about balancing my portfolio. While we have really good data on the past 100 years or so, we really don’t know what the future will bring.
With that in mind, it’s good to have some cash. Even beyond our emergency fund and the money we need for our monthly budget, it is sometimes good to have a portion of our investments in cash. It provides some stability when stock and bond markets are in turmoil.
Fixed income is great because we are getting fixed payments for a fixed duration. It’s nice to have a dependable stream of income.
Equity is the growth engine – see the post on compounding for more info. We need to take advantages of the growth when we’ve got a long time-horizon, and ratchet down our equity allocation as we get closer to needing the money.
When do you need the money?
For many of us the answer is retirement. But if we think about it, it’s much more complex. We may have several savings goals. We may be saving for a child’s college, saving for a new car, saving for a larger home if we have a growing family, and saving for retirement. Each of these goals has a different timeline and should have a different asset allocation.
To make this easier, I set up a new account for each goal and I manage that account’s asset allocation to align with the goal. I have a 529 account for my grandson. He’s 2 so this is 100% in equities. It’s been a wild ride, not in a good way, through 2022 and part of 2023, but I expect the equity market to improve – I just can’t tell you when. As he hits his teen years, I’ll start to migrate some of that into fixed income each year. In his later teens, we’ll move to all cash and fixed income.
I also have a retirement account. Yes, I’m retired now, but I expect to live for a while. Based on average life expectancy, I need to plan to live til I’m 80 or so and possibly longer. That’s a 20+ year time horizon so I should have some money in equities.
Recap:
- It’s important to understand the difference between the 3 key asset classes: Equities, Fixed Income and Cash
- Each asset class has a place in your portfolio
- The allocation needs to change as you get closer to your goal (college, retirement…)
- 100 – your age is a good starting point in planning your equity allocation, but there are other factors to consider
- It can be helpful to create a separate account for each goal so you can manage the allocation more precisely
This is not as daunting as it sounds. Now that we understand what equity, fixed income and cash are and how they behave, we can consider our goals / cash needs and allocate our assets accordingly.
There is no right answer. As we become a more experienced investor, this will become more comfortable. It’s not something we need to think about every day. I typically review this annually. At the end of the year, I review my goals and my allocations and make any necessary adjustments.
Allocation Funds
For those who want to take advantage of the benefits of investing but feel that this is more work than they’re willing to do, there are other great options. The first is allocation funds. This is an actively managed mutual fund in which the fund manager makes decisions on how to allocate the fund’s investments across equity, fixed income and cash to provide a solid return with lower risk. Take a look at the Fidelity Balanced Fund (FBALX) as an example.
Target Date Funds
Another alternative is target date funds. These types of funds manage the asset allocation similar to an allocation fund, but they have the added benefit of managing that allocation with a specific end date in mind. For example a target 2065 fund would manage the allocation for someone who was born in 2000 and expected to retire within a few years of 2065. It would be fairly aggressive today (since we’re over 40 years away from the target date) but would become more conservative as we get closer to 2065. You may notice that target date funds have a higher expense ratio than index funds and may lag their performance. This is because we are paying for a professional manager to manage the allocation and adjust over time, and we are benefitting from exposure to all 3 asset classes.
Whether we choose to buy individual stocks and bonds, we choose mutual funds, or we choose a combination of both, it’s important to have a strategy for allocating our assets across the 3 major asset classes.