I love fashion. I dream about Dior gowns, Chanel suits, and anything McQueen. Recently, I started a trial subscription for Rent the Runway and can’t stop drooling over all the designer threads. As I was putting away my latest delivery of Diane von Furstenberg, Lela Rose, and Robert Rodriguez, it occurred to me that the contents of my closet perfectly illustrated asset allocation.
Let’s all agree that there are three main categories of apparel: clothing, shoes, and accessories. Your closet is probably organized among these broad categories (unless you leave them in a big pile on the floor…ah hem, husbands of America). You may have more of one category over the others depending on your needs and tastes.
Much like organizing a closet, asset allocation divides a portfolio’s investable assets into 3 main buckets (or asset classes):
- Equity / stocks (an ownership stake in a business),
- Fixed income / bonds (a loan to a business or government), and
- Cash or cash equivalents.
If you have #closetgoals like Lisa Vanderpump from RHOBH, you may further sort the three categories into item type, color, style, seasons, occasions (I could go on…) so you can create ideal ensembles for your various purposes. Likewise, each main asset class (except for cash) can be further subdivided based on a set of factors, for example:
- Stocks can be classified by company size (small-, mid-, or large-cap), business metrics (value or growth), and profitability (book value vs. stock price).
- Bonds can be classified by type (government, municipal or corporate), credit quality (high or low ratings), and term (short-, intermediate-, or long-term due dates).
- And both stocks and bonds can be further classified by geography: domestic (i.e., US), developed international (e.g., Europe, Japan), and emerging (e.g., Brazil, Russia, India and China, aka BRIC countries) markets.
These factors can be mixed and matched to build a multitude of asset classes, such as international small-cap stocks, intermediate government bonds, and so on.
So why does asset allocation matter? Well, let’s say your wardrobe only consisted of MC Hammer’s signature outfit. Your style was on fire in the 90s, but now, you’re a fashion faux pas. Like a closet with a plethora of parachute pants, investing your portfolio into only one asset creates too much risk and possibly little reward. By allocating your investments into multiple asset classes, you’ve turned a collection of risk/reward “building blocks” into a tightly constructed portfolio, with an asset allocation optimized to reflect your particular financial goals, risk tolerance, and timeline.
So go ahead and rock those parachute pants, but add other clothes, shoes, and accessories into your wardrobe. Your closet should reflect your unique style, and your investment portfolio should too.
Now that you’re more familiar with asset allocation, I hope you’ll agree that properly tailored, asset allocation is a fitting strategy for any investor seeking to earn long-term market returns.