On Money & More – July 2023

Asset allocation—it’s a term you may have come across in conversations with financial advisors, CPAs, estate attorneys, or while watching business news channels. But what exactly does it mean, and why is it important for your investments? This month let’s go back to basics and talk about portfolio construction.

At its core, asset allocation refers to how you divide your investment portfolio into different categories. There are many different assets, but for today we will focus on three primary components: stocks, bonds, and cash. Stocks offer potentially higher returns but come with volatility, bonds provide fixed coupon payments with limited upside, and cash represents a stable and relatively safe short-term investment. So, why does your asset allocation matter? Well, by combining different asset classes, you can reduce risk through diversification and achieve smoother returns. This is because these assets tend to have different performance patterns and are less likely to move in sync. Creating an efficient portfolio involves finding the right mix of asset classes to maximize expected returns for a specific level of risk.

Financial Advisors tailor asset allocations to meet the unique needs of their clients, considering factors like age and financial goals. Sometimes investors may have different asset allocations for their accounts, depending on the intended beneficiaries and objectives. For example, a newborn grandchild’s college savings plan will likely have a different asset allocation than a retiree’s portfolio.

A general rule of thumb is that younger investors with longer investment horizons can afford to take more risks and thus have more equity-heavy portfolios. They have time on their side and may not need to withdraw money from their investments for decades. Conversely, individuals in the later stages of life tend to have more conservative portfolios as they rely on their investments to cover living expenses during retirement. However, no two of us are the same, and there are many wrinkles to these generalizations.

Let’s take a moment to illustrate this with an example. Imagine a 75-year-old retiree with a more conservative asset allocation: 30% stocks, 50% bonds, and 20% cash instruments. This allocation targets potential growth with the equity portion, while also providing current income through higher-yielding bonds and low-yielding cash. Furthermore, since most fixed income securities’ income are taxable, the retiree may benefit from a potentially lower tax rate due to the absence of labor income.

To further expand on this concept, let’s say our retiree just opened a 529 college savings plan for their newborn granddaughter. Given the longer time horizon (18 years until college), the asset allocation for this specific account could be more aggressive than the retiree’s own investments. Another approach might be to purchase bonds in the account that mature around the time the granddaughter starts college, returning the principal just in time for her education.

Asset allocation can be complex, and knowing when to make adjustments can be challenging. However, studies have shown that asset allocation historically determines up to 90% of an investor’s returns, making it significantly more important than picking individual companies or funds to invest in1. Understanding asset allocation and implementing the right strategy is one of the first steps any investor should take.

1.Source: https://blogs.cfainstitute.org/investor/2012/02/16/setting-the-record-straight-on-asset-allocation/

All opinions and data included in this commentary are as of June 14, 2023 and are subject to change without notice. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or individual investment advice including the asset allocation provided. Nothing herein should be construed as tax advice. This article is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase or sell securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Investing involves risk, including the potential loss of principle. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.