Demystifying Asset Allocation for Beginners

This week’s newsletter focuses on helping beginner investors determine the proper asset allocation that suits you best. First, we’ll review a framework of how to determine your own asset allocation based on your risk tolerance and time horizon. Then, I’ll walk through my personal portfolio asset allocation along with reasoning as to why I structured it that way.

Part 1: Framework for determining your asset allocation:

1. Determine your risk tolerance:

Assess your risk tolerance by considering factors such as your investment goals (retirement, buying a house, etc.) time horizon, financial stability, and comfort with market volatility. Remember to keep a long-term outlook and keep the quote below in mind:

“Volatility scares enough people out of the market to generate superior returns for those who stay in.” – Jeremy Siegel

Take stock of your financial situation and determine how much risk you’re personally willing to take on. While most beginner investors may be cautious in approaching the stock market, it’s important to remember that the earlier you start investing, the more time your portfolio has to grow and weather the ups and downs of the market. Therefore, it may be a good idea to adopt a more aggressive portfolio allocation to generate optimal returns.

1. Understand asset classes:

Stocks: Historically, stocks have offered higher potential returns but come with higher volatility and risk. Stocks are suitable for long-term growth-oriented investors. Different indexes have different historical returns based on their riskiness. For example, the tech-focused Nasdaq (QQQ) has an average annualized return of 10.4% for the past 30 years. Conversely, the S&P 500 Index (SPY) has had an average 8.5% annual average return adjusted for inflation.2

For beginner investors, holding a diversified broad-market index fund such as the VOO or SPY are a good starting point to obtain diversified stock market exposure for minimal fees. This will ensure that your portfolio is not only diversified across asset classes (stocks, bonds, cash, etc.) but also within the stock asset class itself - without having to pick individual stocks.

Bonds: Bonds are generally considered less risky than stocks and provide income through regular interest payments. They are suitable for investors seeking stability and income. US Treasury Bonds are considered the safest in the world and at the time of writing yield 5.5% via a 6-month treasury bond.

This means that you essentially exchange your cash for an I.O.U. from the US Federal Government and in 6 months they pay you back the principal plus the 5.5% interest you earned.

Cash: Cash or cash equivalents are highly liquid and offer stability but typically provide lower returns over the long term. Currently, the best High Yield Savings Accounts are offering 4% to 5.05% APY on FDIC-insured cash deposits.

HYSAs are some of my favorite accounts to keep cash in because the money is not tied up for 6 months compared to a bond (cash can be withdrawn at any time for no penalties/fees) and the returns are nearly on par with bonds.

Real Estate: Real estate offers diversification benefits by introducing an asset class with different risk and return characteristics compared to stocks and bonds. Real estate can generate returns via rental income and appreciation of the underlying property value over time. It’s important to remember that investing in real estate carries its own unique risks, such as property market fluctuations, maintenance costs, and potential tenant vacancies.

Crypto and Alternative Assets: Cryptocurrencies generally have higher volatility and risk to reward profiles than stocks and are considered high-risk investments. Investors considering cryptocurrencies should carefully allocate their funds to minimize potential loss due to market volatility or hacking. Only invest what you’re willing to potentially take a 50% loss on.

Although it involves high volatility, since 2011, the cumulative growth of Bitcoin has exceeded 20,000,000%, far surpassing the cumulative growth of 541% for the Nasdaq 100 Index and 282% for major US stock indices. Adding a small amount of Bitcoin and other crypto exposure to my portfolio makes sense to me personally as I believe in Bitcoin as a store of value over the long term and believe that the crypto industry will continue to develop over time as well. Investors should do their own research and determine if it makes sense to them before deciding to invest.

1. Consider asset allocation models:

Conservative portfolio: A conservative portfolio focuses on preserving capital and generating income. It typically has a higher allocation to bonds and cash, with a smaller portion allocated to stocks. These portfolios are generally good for people who are approaching retirement age and are more focused on wealth protection than portfolio growth. Here’s an example of how that would be structured:

Moderate portfolio: A moderate portfolio aims for a balance between income generation and long-term growth. It typically has a relatively equal allocation to stocks and bonds, with a smaller portion allocated to cash. For Example:

Aggressive portfolio: An aggressive portfolio emphasizes long-term growth and capital appreciation. It typically has a higher allocation to stocks, with a smaller allocation to bonds and cash. This portfolio type is better suited for people with long investing time horizons who may be focused more on portfolio growth than wealth protection. Example:

1. Rebalance periodically:

Regularly review your investment portfolio to ensure it remains aligned with your financial goals and risk tolerance. Reassess your asset allocation periodically, especially during major life events, changes in financial circumstances, or shifts in your investment horizon. This will ensure your portfolio remains aligned with your risk tolerance and investment goals.

1. Maintain a long-term perspective

Maintain a long-term perspective when investing. Short-term market fluctuations and volatility can be unnerving but focusing on your long-term goals can help you stay on track. Avoid making impulsive investment decisions based on short-term market movements. Stick to your investment plan and consider adjustments only based on thorough research and analysis. Remember that staying invested in the market over the long term is even more important than your asset allocation.

Part 2: How I’m allocating my assets for the second half of 2023

1.     High-Yield Savings Account (50% of Assets)

About half of my money is currently in a High Yield Savings account. While I wouldn’t typically recommend younger folks have this conservative of a portfolio early on in their investing journeys, my current cash allocation is this high due to my cash needs in having to repay student loans soon. My plan is to pay off any loans with an interest rate higher than 5% once payments start back up and then slowly pay off the rest as I’m able to. This will significantly reduce my cash position.

The yield on the Wealthfront Cash Account (FDIC-insured) is fantastic. You get 4.55% base APY but if you refer a friend or join via a referral link like the one above, the yield goes up to 5.05% for 3 months.

These boosts are also stackable, so the more friends you refer, the longer your 5.05% yield lasts. I also like that their dashboard shows all your accounts across various financial institutions, so it’s a great way to track your assets, liabilities, and net worth.

2.     Roth IRA (21% of Assets)

I’m on track to max out my Roth IRA this year, setting aside $500/month towards this in automatic transfers from my checking to savings account, I will then deposit the money into my IRA at the end of the year to be invested in the S&P500. This account is about 80% of my retirement portfolio (Roth IRA & 401k) and is solely invested in the S&P500 via to give me diversified US stock market exposure with minimal management / headache.

3.     Traditional 401(k) (7% of Assets)

I use this account as a medium-term trading account where I hold a basket of hand-picked stocks mostly based on technical and macroeconomic factors. The idea behind this account is that this may be the 20% of my stocks that produce 80% of my returns (if my chosen investments do well). I’ll write about my reasoning behind the stocks in this account in a future post, but here’s a snapshot of my current holdings:

4.     Bitcoin (10% of Assets) and Crypto Trading (3% of Assets)

As an alternative asset to holding inflationary dollars, Bitcoin has been sprinting in 2023, out-pacing other asset classes by a wide margin (chart from ExecSum)

I expect this trend to continue for two reasons. Firstly, the Federal Reserve is nearing the end of its rate-hiking cycle and will likely only raise rates once or twice more this year. After that, there will likely be a pause followed by rate cuts which will flood the system with more dollars, thus driving up the BTC/USD currency pair. The timing for this is hard to predict, but I’m betting that the market will be forward-looking enough to begin to price in rate cuts at some point later this year.

Secondly, the Bitcoin halving is set to occur around April 2024. Bitcoin mining block reward halvings have historically kicked off bull-markets for Bitcoin, and a Fed pause and potential cuts later in 2024 or 2025 would only add fuel to the fire.

5.     Miscellaneous Checking & Saving Accounts (9% of Assets)

These accounts store just enough cash to pay the bills, nothing too exciting here. Note that some banks like Truist are giving out pretty big cash bonuses for people who open new accounts with them, given they meet minimum requirements (I’m not affiliated with Truist but thought readers may find that bonus helpful).

That’s it for this week! If you found this information helpful, share it with someone who may benefit. Feel free to comment or email me back on any personal finance or business-related topics you’d like to learn more about.