Asset Allocation – Include Future Contributions?

by Mike Holman

One of my favourite investment topics is asset allocation – trying to figure out what your division between stocks and bonds should be in your portfolio.   I read a comment on this idea recently written by the excellent blogger Michael James who writes an excellent financial blog.

Normally when you are trying to figure out your desired asset allocation you consider your existing portfolio.  If you have $100k then you might decide to go with 70% stocks and 30% bonds.  Within those major asset classes you would probably have more detailed asset classes such as Canadian equities, US equities etc.

This approach works quite well for investors who have a fairly significant portfolio assembled.  But what about someone who is just getting started?  They might be in the situation where their portfolio is quite small but they are making large contributions to it.  An example could be someone who has just paid off their mortgage and now has quite a bit of extra cash to contribute to their retirement savings.

Does asset allocation matter if your contributions are a significant percentage of the portfolio?

I would say no.  If an investor has a portfolio value of $5,000 on Jan 1 and is planning to contribute $1,000 per month then it’s not worth worrying about keeping his portfolio at the perfect allocation.  One of the main reasons for asset allocation is risk management – either you want to protect your assets or are willing to risk them for a greater future reward (or something in between).

If you are in this situation then I would still consider coming up with some sort of asset allocation model (ie 75% stocks, 25% bonds etc) although it’s not really necessary in the early stages.  If you are buying securities with transaction fees such as stocks or exchange traded funds then it might be cheaper to just buy a lot of one investment at a time.   Even if you are buying index funds or managed mutual funds which don’t have transaction costs then don’t worry too much about the allocation until you have enough money to assemble a proper portfolio.

At what point should the asset allocation matter?

Tough to say – I would suggest that rather than think of a dollar figure – a ratio of yearly contributions to portfolio size might be more meaningful.  From a risk point of view – someone with an investment portfolio of $10k and annual contributions of $20k probably isn’t that worried about the original $10k from either a safety standpoint or a performance standpoint.  It just doesn’t really matter much in the beginning.

On the other hand if an investor has $20,000 and is contributing $1500 per year then they should concern themselves with designing a proper portfolio since they are at a point where the contributions are a small percentage of the portfolio.

Another factor might be the normal variances of the portfolio – if you assume a possible range of -15% to +15% (in most years) for a mostly equity portfolio then if the 15% estimate is larger than your contributions then that might be another point where your asset allocation plays a bigger part of the risk management rather than your contributions.

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