3 Big Mistakes Academics Make in Asset Allocation
- What is asset allocation and why is it vital for a successful retirement
- Why selecting the right mutual fund(s) may not be enough
- The risks of investing your portfolio too conservatively too soon
- How the set-it-and-forget-it approach hurts your future retirement
Participating in an employer-sponsored retirement plan is the initial step that university professionals make in saving for retirement. Benefits departments do a great job of enrolling people and encouraging them to take advantage of employer-matched contributions.
After that, many employees pick a few mutual funds and think the work is done. This, however, is where very costly errors can occur. The “set it and forget it” approach can force you to work several years longer than you desire and can greatly impact the quality of your retirement years.
Diversification is a well understood as a general concept, but far too few are properly informed on the related topic of asset allocation.
What is Asset Allocation?
Asset allocation is a portfolio’s mix of high-level asset classes such as equities, fixed income, real estate, and commodities. Determining an appropriate asset allocation mix is the first and most important step in creating a properly diversified portfolio. These asset classes tend to move in an uncorrelated fashion in response to various market conditions. Constructing a portfolio with the right mix of these components will allow one to meet their long-term financial goals without stressing them out during market declines.
The asset allocation decision will determine over 90% of your portfolio’s risk and return characteristics. For example, a portfolio comprised of 80% equities and 20% fixed income will generate long-term growth, but could see its value bounce around wildly from month to month. Conversely, a portfolio of 20% equities and 80% bonds will provide short-term stability and income, but could fail to provide adequate growth.
Surprisingly, selecting “good” mutual funds plays a very minor role in a successful financial outcome. Poor mutual fund selection can be overcome, but inappropriate asset allocation decisions can be disastrous.
Here are the three most common asset allocation mistakes:
1) Investing Too Conservatively
The longer your investment time horizon, the more equities you should have. Even recent retirees may have 30 years left to live, so be careful not to get too conservative too soon. Many people perceive risk as losing money in the near-term. A bigger risk could be not growing your money enough to fund a long retirement. We’ve had new clients come to us that had previously been holding nearly all of their funds in overly conservative investments since start of their career or since the financial crisis in 2008. This concentration in safe assets cost them hundreds of thousands of dollars of growth and pushed their retirement back several years.
2) Investing Too Aggressively
Two mishaps can occur by investing too aggressively. First, you may subject yourself to emotional errors such as selling your investments after a sharp market decline, and then, inadvertently missing out on the ensuing stock market rally. The market is going up three-fourths of the time, so you are better off selecting an allocation mix that you can ride through up and down markets. Second, if you are retired and taking money out of your portfolio to cover monthly living expenses, the portfolio may struggle to recover from a sharp stock market decline. This is not an issue when you are investing more funds with every paycheck (i.e. “buying low”) instead of taking money out when stock prices are down (i.e. “selling low”).
3) Failing to Adjust Allocations
Rebalancing is the process of periodically bringing your portfolio back to the targeted asset allocation mix. Even if you initially established a proper asset allocation, market fluctuations and new contributions can move your portfolio away from your targets. Equities markets are far more volatile than fixed income instruments, so a 50% equity allocation could quickly change to 60% or 40% allocation depending on the direction of the market. We suggest rebalancing at least once per year or more frequently in the event of large market moves. Finally, you may want to change your asset allocation targets as life situations evolve (e.g. retirement, aging, inheritance, illness, etc.).
A trained investment professional can help determine an appropriate asset allocation after a thorough review of your situation and risk tolerance. Additionally, by diversifying within asset classes (e.g. buying U.S. and international stocks), the professional can seek to maximize your return given your asset allocation. Understanding what you have and establishing a process for your asset allocation will keep you on track to meeting your long-term goals.
- To learn more about our investment process, read this report: The 3 Hidden Risks of Consolidating Your Retirement Accounts
- To learn more about the importance of seeking guidance from an independent fiduciary, read this report: Who Can You Really Trust With Your Financial Future?
Have a Question?
As part of our commitment to promoting financial literacy among university professionals, you can schedule a 15-minute phone call with an expert at Filbrandt & Company to learn how these important topics apply to your own situation.