By Joseph Reinke, CFA, CEO of FitBUX, Inc.
- The purpose of this article is to explain in simple terms what asset allocation is.
We often hear from “financial professionals” that we need to diversify and to make sure our “asset allocation” reflects our goals. To quote a recent comment from a friend of mine, “Great advice…what does it mean?” Asset allocation is simply how and where we invest our money. To explain asset allocation and how it is used to meet our financial goals, I will use a simple illustration.
Asset Allocation Illustration
Picture this… You are contemplating purchasing a home by the beach. You have three choices:
- Buy a penthouse suite on the 40th floor of a beach resort;
- Buy an apartment on the second floor of the same beach resort; or
- Keep your money in an FDIC insured checking account at your bank and move in with your parents.
The Penthouse Suite
The penthouse suite sounds the best. You have the greatest view and the value of the suite will increase the most relative to the other two options since these suites are limited in number. Who wouldn’t want that? However, as pretty as it sounds, it also comes with the greatest risk when compared to the other two options below, here is why:
Say some tourist decided to get drunk in the floor restaurant. He accidentally knocks over his Flaming Doctor Pepper and catches the bar on fire. The fire spreads quickly to the kitchen and now there is a grease fire. Five minutes later and before the fire trucks can get there, the fire hits a gas tank and down comes the resort hotel.
Since you are on the top floor, you have little chance of getting out and even if you do, your investment is now worthless.
The Second Floor Apartment
The second floor apartment would also be a good option: you will have a place at the beach, it will appreciate in value because of the location, and you will have some cash left over since it was less expensive than the penthouse suite. Best of all, you have a greater probability of getting out of the fire alive.
Therefore, after the fire, your residential investment may be gone but you are not dead broke.
Keep Your Money in The Bank
You choose this option and point your finger and laugh at those that lost their investment in the beach resort since you were not impacted by the fire. However, let’s say there was no fire or the resort was able to rebuild; then those that bought would most likely gain their investment back and have greater appreciation of value.
For you, although your money is safe, it isn’t going to appreciate…plus you still need a place to live and you probably want to move out of your parent’s house one day.
The Moral of the Story
The three options can be broken down as follows:
- Option 1 has the greatest potential reward but the greatest risk.
- Option 2 has a moderate level of risk and reward potential.
- Option 3 has no risk but extremely low reward.
Asset allocation is the decision of what option we choose…or more importantly, the combination of choices and probabilities. For example, you decide to pursue option 2, you could also buy 1 week of a time share of the penthouse, and put the rest of your savings in the bank. Now you have an opportunity of appreciation but you can also survive if the “house” burns down. If you want to take a little more risk, you could take some of your cash and buy a second week of the time share.
Back to the world of finance…In the financial world, we equate option 1 to equities (equities is a fancy word that most people know as stocks). Option 2 are fixed income investments such as corporate bonds or long term CDs. Option 3 is the same as our illustration, cash in the bank earning nothing (and yes I am aware there are more allocation options but that is for another article).
Asset allocation is based on your risk preferences and desire for return. Do you want to take more risk for potential return and buy the penthouse or keep your money in the bank? Everyone’s preferences are different as well as his or her allocation….