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 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 are 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 it 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 government benefits, and will practice tough love if you're not on track with your savings rate. DIYers, meanwhile, can avail themselves of a combination of 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 children. On this front, I especially like financial planning guru Michael Kitces' advice to empty nesters; his research suggests that once post-secondary education 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 luxury vehicle bring as much joy as you would get from a more modest one, if the lesser ride afforded you the opportunity to take your family on several amazing trips as well?
Of course, 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 paydown? 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. 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. Look at the tax benefits on the loan too, in the case of education loan and home loan.
It's also worth noting that debt paydown doesn't provide liquidity, obviously, so if you are going to need the money any time soon, it's not an appropriate strategy.
- Your human-capital allocation
Our human capital -- the earnings power of our skills, education and experience -- is the most valuable asset that most of us will have in our lifetimes. Are you using yours in a way that maximizes your returns over your lifetime?
Investing in human capital -- via additional education or training -- is close to a slam-dunk deployment of funds for early-career accumulators. If you can increase your earnings power with such an investment, you have a long time until retirement to benefit from it. The calculus isn't as simple as you get older; lifetime earnings may not offset the outlay of money and time for costly training later in life. Yet mid- and late-career accumulators should still make an ongoing investment in their own human capital -- taking advantage of continuing education programs and conferences to enhance their skills, networking, and simply staying current on the latest news and developments in their fields. And no matter your life stage, staying current on the latest major technology developments, both on and off the job, is a crucial way to ensure that you stay relevant.
- Your time-on-earth allocation
Squishier, but even more important than all of the above: How are you allocating your precious time? Have you found the right balance of activities that make money, bring you joy and do some good in this world? Better yet, can you find an occupation that balances all three in a way that's agreeable to you?
I can't say I'm an expert on this, but this is the mother of all allocation decisions. It deserves frequent monitoring
This post initially appeared on Morningstar.com but has been edited for an Indian audience.
