Retirement planning

Understanding the impacts of portfolio allocation

By April 26, 2019 No Comments

Understanding allocation is a very important concept when it comes to managing your investments. Allocation refers to how much money you invest in a particular investment or market segment. The best way to think of allocation is on a percentage basis. For example, if the total value of a portfolio is $100,000 and $5,000 of that is invested in Apple stock, that means the portfolio has a 5% allocation to Apple. In the industry, we would say that Apple has a 5% weighting in the portfolio.

 

Allocations are important because they help us identify and quantify the risks we have in our portfolio. Sticking with the Apple example above, we can start to model out how the return we get in Apple stock will impact the performance of the entire portfolio. If we expect Apple to either go up or down 20% on the year, we can model out a total portfolio impact of plus or minus 1%.

 

How do we arrive at the 1% figure? We take our expected return (20%) and multiply it be the allocation of Apple in the portfolio (5%) to arrive at a figure of 1%. Do not forget that we are not just modeling upside expectations but the possibility of downside too, so our expected portfolio impact on the year from our investment in Apple stock is +/- 1%.

 

Once we have our expected portfolio impact from on a percentage basis, we can then determine the impact in dollars on the total portfolio. To do this, we multiply the expected portfolio impact (1%) by the total amount of the portfolio ($100,000) which computes to $1,000. Thus, if Apple performs within our expectations (either up or down 20%) our total portfolio will either rise or fall by $1,000.

 

This is useful information because it helps us identify potential risks in the portfolio. Some may argue that a 5% allocation in Apple stock is too small. But did you know that during a single 4-month period in 2018, Apple stock dropped close to 35%? Here’s how that type of drop would have impacted a $100,000 portfolios depending on the weighting Apple had:

 

AAPL stock:

Portfolio weightPortfolio ImpactDecline in Portfolio
5%1.85%$1,850
10%3.7%$3,700
20%7.4%$7,400

 

A hypothetical $100,000 portfolio with a 20% allocation to Apple in 2018 lost $7,400 in value just from the Apple position! This doesn’t mean you can’t invest that much in Apple stock, as in general, the stock has performed very well. However, before allocating that much to one stock, you should ask yourself, “Am I comfortable holding through the worst case scenarios?” If the answer is yes, then you are better suited for aggressive risk-taking. If the answer is no, then you should focus on a more diversified investing approach.

 

We personally believe in a more diversified investment approach. That’s the main reason we choose to invest in ETF’s that track a market index as opposed to betting on one individual stock. This approach lowers the risk in our investment strategy. Furthermore, a stock like Apple would be included as a holding in one of the ETF’s we purchased anyway. So even though we’re not buying Apple stock individually, we would still have investment exposure to it through our use of ETF’s.

 

To illustrate why we believe in our strategy instead of picking individual stocks, let’s compare the performance of the ETF we invested in to own Apple versus owning Apple outright. We invest in Schwab’s large-cap growth ETF (ticker: SCHG), and it dropped 21% during the same period that AAPL fell 37%:

 

SCHG ETF:

Portfolio weightPortfolio ImpactDecline in PortfolioSavings vs Apple
5%1.05%$1,050$800
10%2.1%$2,100$1,600
20%4.2%$4,200$3,200

 

As you can see from the table above, having a 10-20% allocation in SCHG was not nearly as damaging to our portfolio as if we had that same allocation to Apple stock individually. A 10% allocation to SCHG saved us $1,600 compared to a 10% allocation to Apple stock over the same time period.

 

When you are evaluating your portfolio, try to identify where your risk is. You may not even realize how much of your portfolio is allocated to a particular stock or market segment until you do the math and figure it out for yourself. If you don’t want to do it yourself, we’re happy to help. If you’re comfortable doing it yourself, just make sure you’re not making these 3 common mistakes.

 

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