How to optimize asset allocation for your clients

Asset allocation is the process of dividing investments among different asset categories. It is one of the most important parts of creating your clients’ portfolios. The way assets are allocated can have a bigger impact on long-term results than the selection of individual securities. A thoughtful asset allocation strategy helps manage risk, pursue growth, and align portfolios with investor objectives.

In this article, Wealth Professional Canada explores what asset allocation is and why it matters. We’ll also look at how financial advisors can use it to help their clients achieve their financial objectives. Plus, we’ll explore client profiles, common mistakes to avoid, and more.

What is asset allocation?

Asset allocation is the process of spreading investments across various asset classes. The main goal is to balance risk and earnings by adjusting the percentage of each asset in a portfolio. This can be according to the client’s goals and time horizon. Even their risk appetite matters.

Each asset class has its own risk and return characteristics. Equities can offer higher long-term returns but might come with more volatility. Fixed income provides income and stability but might have lower growth potential. Cash offers liquidity and safety but usually earns the lowest returns.

Watch this video to learn more about asset allocation:

In asset allocation, investors need to split up their portfolios with different types of investment vehicles to determine one’s investment results.

Why asset allocation is important

Choices made during asset allocation decisions account for most of a portfolio’s risk and return over time. Choosing the right asset mix helps protect against market swings and provides opportunities for growth. It also helps investors stay invested during periods of uncertainty.

A well-designed asset allocation strategy can:

• reduce the impact of poor performance in any single asset class
• provide a smoother investment journey
• help clients achieve their investment goals
• support better risk-adjusted returns over the long term

Main asset classes

There are three main asset classes in most portfolios:

• Equities: These are shares of companies. Equities offer the potential for higher returns and capital growth. They also come with higher risk and more price fluctuations.
   
• Fixed income: This includes government and corporate bonds and other debt instruments. Fixed income investments provide regular income and can help stabilize a portfolio. Their performance depends on factors such as interest rates and duration.
   
• Cash: Treasury bills and money market funds provide liquidity and safety. Cash and cash equivalents are useful for meeting short-term needs but usually offer lower returns than equities or bonds.

Some portfolios include alternative assets for further diversification. These can include:

• real estate
• private equity
• commodities
• infrastructure

Alternative investments can help reduce risk and provide returns that do not move in the same direction as traditional markets.

What is a good asset allocation?

There’s no one-size-fits-all asset allocation. However, selecting the right asset allocation is a personalized process. Financial advisors should consider these factors:

• Investment goals: What are your clients saving for? Retirement, a home, education, or another goal? The purpose of the investment shapes the allocation.
   
• Timeframe: How long does the client plan to invest? Longer timeframes allow for more risk and higher equity allocations. Shorter timeframes might require more fixed income and cash.
   
• Risk tolerance: How comfortable are your clients with market ups and downs? Understanding risk tolerance helps set expectations and prevent emotional decisions during market swings.
   
• Financial situation: Do your clients have other sources of income or assets? Are there upcoming expenses? The overall financial picture affects how much risk is appropriate.
   
• Investment knowledge: Some clients who understand investments might be more comfortable with complex asset mixes. Those new to investing might prefer simpler allocations.

You can use questionnaires and financial planning tools to assess these factors and recommend a suitable asset allocation.

What is a good asset allocation by age?

A good asset allocation by age often follows the “rule of 110.” This simple guideline can help you decide how much of a client’s portfolio should be in stocks versus bonds and cash. To use it, subtract the client’s age from 110. The answer is the percent of the portfolio to keep in stocks.

For example, if a client is 40 years old, 110 minus 40 equals 70. That means 70 percent of the portfolio could be in stocks, and the remaining 30 percent in bonds and cash.

This rule is just a starting point. If a client is comfortable with more risk, they might choose to have a higher percent in stocks. If they prefer less risk, more of the portfolio can be kept in bonds and cash. Personal goals and risk tolerance should always guide the final decision.

Examples of asset allocation

Asset allocation can take many forms. Here are some common examples:

Growth-oriented portfolio

• 70 percent equities
• 25 percent fixed income
• five percent cash

This mix is suitable for clients with a lengthy time period and higher risk tolerance. It aims for capital appreciation but accepts more volatility.

Balanced portfolio

• 50 percent equities
• 40 percent fixed income
• 10 percent cash

A balanced allocation seeks both growth and stability. It is suitable for clients with moderate risk tolerance and medium- to long-term goals.

Conservative portfolio

• 30 percent equities
• 60 percent fixed income
• 10 percent cash

This mix is designed for clients who prioritize capital preservation and steady income growth. It is suitable for those closer to retirement or with lower risk tolerance. Remember, the right asset allocation depends on the client’s unique situation. There is no one-size-fits-all formula.

Strategic vs. tactical asset allocation

There are two main approaches to asset allocation:

Strategic asset allocation

This is a long-term approach. The financial advisor sets a target mix of assets based on the client’s financial profile along with their risk tolerance and expected results.

The allocation is reviewed periodically and rebalanced as needed. Strategic allocation focuses on maintaining discipline and avoiding emotional reactions to market movements.

Tactical asset allocation

This approach involves making short-term adjustments to the asset mix in response to market conditions or economic outlooks. Tactical allocation can help take advantage of opportunities or manage risks, but it requires skill and discipline.

Some financial advisors use tactical shifts sparingly, as frequent changes can increase costs and risk.

Watch this short clip to better understand both approaches:

Want to know how asset allocation deals with risks? Read this for more.

Diversification in asset portfolios

Diversification can go hand-in-hand with asset allocation. When spreading investments across different asset classes and sectors, you can reduce the impact of poor performance in any one area. Diversification does not guarantee profits or protect against losses, but it can improve the risk-return profile of a portfolio.

Home country bias

For some clients, home country bias can be a common risk. The Canadian market is concentrated in a few sectors, such as financials and energy. Including international equities and alternative assets can provide broader diversification and reduce reliance on the domestic market.

Adjusting asset allocation over time

Asset allocation is not a set-it-and-forget-it strategy. Portfolios need regular review and adjustment. Market movements can cause the asset mix to drift from its targets. Rebalancing helps bring the portfolio back in line by selling assets that have grown too much and buying those that have lagged.

Life events can also change your clients’ needs. Retirement, inheritance, or major expenses might require a new asset allocation. You should review portfolios at least once a year or after significant changes in the client’s situation.

The COVID-19 pandemic was a reminder of the need for flexibility. Many investors had to adjust their asset allocation to respond to market shocks and changing goals. A disciplined approach to rebalancing can help clients stay on track.

Asset allocation strategies for different client profiles

The right asset allocation strategy is not the same for everyone. Instead, it should be tailored to each client’s unique situation. Here are some common client profiles and the asset allocation strategies that often suit them best:

Very conservative clients

Very conservative clients are focused on protecting their capital and earning steady income. They are uncomfortable with large swings in the value of their investments. For these clients, portfolios often have a high allocation to fixed income, such as government and high-quality corporate bonds.

You can also recommend allocating a huge portion in cash or cash equivalents. Equities make up only a small part of the portfolio. This approach helps minimize risk and provides stability, but it also means lower potential for growth over the long term.

Conservative clients

Conservative clients are willing to accept a bit more risk for the chance of modest growth. Their portfolios might include a larger share of bonds and a smaller allocation to equities.

This mix allows for some capital appreciation while still focusing on income and stability. Conservative clients might be saving for retirement or other important goals, but they do not want to see large drops in their portfolio value.

Balanced clients

Balanced clients want both growth and protection. They are comfortable with some risk but want to avoid big losses. A balanced portfolio usually includes a mix of these three: Canadian stocks (can also have international equities), fixed income, and some cash.

This approach aims to provide a reasonable rate of return while reducing the impact of market downturns. Balanced strategies are popular for clients with medium- to long-term goals and a moderate risk tolerance.

Growth-oriented clients

Growth-oriented clients are focused on building wealth over time. They understand that markets can be volatile and are willing to accept short-term ups and downs for the chance of higher long-term returns.

Their portfolios have a higher allocation to equities, both Canadian and international, and a smaller share of bonds and cash. This strategy is best for clients with a long investment horizon who can stay invested during market swings.

Aggressive growth clients

Aggressive growth clients aim for the highest possible returns and accept the highest level of risk. Their portfolios are heavily weighted toward equities, with little or no fixed income or cash. These clients are comfortable with large fluctuations in value and are focused on long-term growth.

This approach is suitable for those with a high-risk tolerance and a long timeframe before they need to access their money. The right asset allocation always reflects the client’s risk profile and timeline. As such, you need to review and adjust the allocation as your clients’ needs and market conditions change.

Common mistakes in asset allocation

Even experienced investors can make mistakes with asset allocation. Here are some pitfalls to watch for:

• Overconcentration: Putting too much money in one asset class, sector, or country increases risk. As mentioned above, diversification helps reduce this risk.
• Chasing performance: Switching asset allocation based on recent returns can lead to buying high and selling low. Stick to the plan and avoid emotional decisions.
• Ignoring fixed income quality: Reaching for yield by buying lower-quality bonds can hurt portfolios during downturns. Focus on credit quality and diversification.
• Neglecting rebalancing: Failing to rebalance allows portfolios to drift away from their targets. Regular reviews and adjustments are essential.
• Disregarding client behaviour: A well-designed asset allocation fails if clients cannot stick with it during market volatility. Set realistic expectations and provide guidance during tough times.

Growing client portfolios with the right asset allocation

Asset allocation is a powerful tool for managing risk and pursuing growth. It is not about picking the hottest stocks or chasing short-term trends. Instead, it is about building a portfolio that reflects your clients’ goals and preferences. The same is true for risk tolerance and time horizon.

When you follow a disciplined asset allocation strategy, you'll be able to help your clients achieve their investment objectives and weather the ups and downs of the market.

To read more about asset allocation and other related topics, check out our Practice Management page.