Morningstar's director of personal finance Christine Benz wrote this post for morningstar.com. Below is an extract.
What comes to mind when you hear the words asset allocation? Stocks, bonds, and cash, right? Maybe commodities, real estate, and a dash of precious metals thrown in for good measure. Perhaps alternative investments for those who are so inclined.
Those are certainly the main assets in the conventional asset allocator's toolkit. But I think investors spend too much time on this type of asset allocation--and the smaller-bore issues that follow from it, such as selecting specific funds, ETFs, and stocks--while ignoring even more basic asset-allocation issues.
What do I mean by more basic--so basic that they're downright primordial--asset-allocation issues? I'm talking about really big-picture allocations, like how you how you allocate your financial assets across your total opportunity set: spending versus saving, investing versus debt pay-down. Whether you've invested enough in yourself and maximizing your human capital.
How you spend your money, and your time, too.
In the end, the decisions you make on these big-picture asset allocation questions will define whether you find success in life, and not just the financial kind.
Here are the components of your "primordial" asset allocation.
Your Saving versus Spending Allocation
It's hard to argue that any other allocation is more important to the success or failure of a financial plan than how much of your paycheck you spend and how much you save for later. So why is that so many investors who are scrupulous about various aspects of portfolio management--their asset allocations and fund expense ratios, for example--are loosey goosey when it comes to their savings rates?
Most people undersave, unfortunately, but I've also encountered a healthy contingent of drastic underspenders, especially among older folks.
One possible explanation is that it can be devilishly hard to figure out how much you'll actually need, especially for the ultralong-term goal of retirement: You don't know how long you'll live, for one thing, or what market returns will be over your time horizon. Yet there are still some ways to put a finer point on whether your savings rate is adequate.
Seeking guidance from a holistic financial planner is the gold standard. A good planner can help you quantify your goals, taking into account anticipated lifestyle changes in retirement as well as external assets like pensions, and will practice tough love if you're not on track with your savings rate. DIYers, meanwhile, can avail themselves of a combination of online tools and benchmarks.
If it looks like your savings rate has been inadequate to date, don't beat yourself up. Life is expensive, especially if you're raising kids and paying for college. On this front, I especially like financial planning guru Michael Kitces' advice to empty nesters; his research suggests that once college is out of the way and kids are out of the house, late-career accumulators have the potential to turbocharge their retirement savings.
Your Spending Allocation
Whether you're thinking about it or not, you're also making important decisions within the spending slice of your household finances. How are you apportioning your money across short- versus long-term expenditures? Are you prioritizing spending on stuff or on experiences? Does that expensive SUV bring as much joy as you would get from a more modest vehicle, if the lesser ride afforded you the opportunity to take your family on several amazing trips as well?
These are really personal decisions; I can't say that any one set of spending priorities will work for every household. Maybe you really do need that expensive SUV or daily Starbucks coffee to feel OK; I'm not here to judge. My point is to be mindful about the choices you're making, and if you can find spots to economize without hurting your quality of life too much, take advantage of them. I also like to remember the words of my dear mom when I'm tempted to keep up with the Joneses: "People think about you much less than you might imagine, dear. You're lucky if they think about you for 30 seconds."
Your Household Capital Allocation
This is another allocation decision that's way underdiscussed in financial circles. Assuming an investor has a finite set of funds to direct in a given month or year--and that's the case with all of us--how much of that amount should go to investing versus debt pay-down? Many households wing it on this front, but they could actually put a little bit of math into the decision-making.
Debt paydown, after all, promises a guaranteed return that's equal to whatever interest rate you're paying (less any tax breaks you receive for maintaining the debt, such as home loan principal and interest deduction). That makes it fairly easy to calculate the return on investment of money steered toward paying down loans. Without a crystal ball, determining a return on investment for investing is more difficult, though the historic returns for various asset classes are a good starting point when calculating your portfolio's expected return.
Armed with some numbers on the expected return on your debt paydown versus investing in the market, you can then make well-founded decisions about how to allocate your capital. High-interest revolving credit card debt? Easy--pay it off, as it's impossible to out-earn that guaranteed rate with any type of investment. It's worth noting that debt pay-down doesn't provide liquidity, obviously, so if you are going to need the money any time soon, it's not an appropriate strategy.
