Being able to determine early what is our current asset allocation is one of the important steps to build a path towards Financial Independence.
Knowing where you’re going starts with knowing where you start from. The gap is where we will invest our hard-earned dollars and get our money to work for us.
Because this isn’t a trivial process, the results can be quite surprising!
One easy way to find out what your asset allocation is is to use an online tool like Personal Capital. You can link all your accounts to the app and it will (mostly automatically) classify your accounts’ content in the proper asset class. It has the added benefit of updating it regularly so once it’s set up, you do not have to redo your calculations and can instead focus on maintaining the asset allocation you determined.
But let’s take the example of David, a 30-something on its way to FI, who bought a house several years back and has been diversifying its investments early in his career. David is a hard worker and he would like to work out his asset allocation in a spreadsheet to understand the mechanics and the impact of each account on the overall allocation.
1. Use a template
I am proposing below a generic template that I used myself to determine my initial asset allocation and I’ve listed all of David’s accounts, some of the most common account types. You could have more or less accounts to list, the idea is to capture here 100% of where your money is invested in assets.
On the left, the 4 major asset classes are represented : stocks, real estate, bonds and cash, which is where David will enter the asset allocation for each of the accounts listed.
On the right, he will enter the Account Value in $. The % of the total is an added calculation that I would recommend to get a better idea of the proportion of each account in the total.
2. Identify the asset class(es) in each account
Once all accounts are listed, David will log in all of his accounts to find out how they are allocated on the different asset classes. Typically, only the investment accounts like 401k, IRA, post-tax accounts will have a mix of assets, the other will be 100% stocks (eg. company stock), 100% real-estate (eg. house), 100% bonds (bonds or loans to individuals) or 100% cash (checking, savings, …).
3. Determine your overall Asset Allocation
Now that David was able to collect all asset allocations, to find the Overall Asset Allocation, 2 additional calculations are required:
- Sum all your accounts values: this is the aggregate value of all accounts combined. David’s total here is 335k$
- Determine the Weighted Average Asset Allocation per asset type: this sounds super fancy but luckily Excel has a super useful function in the name of sumproduct. See the screenshot below. Duplicate for each asset type and voilà!
The document is available here as a Google Spreadsheet
The 4 values you obtain in the lower left part of the table is your current Asset Allocation. The total of all 4 should be 100%.
In David’s example :
The Overall Asset Allocation is 36%/33%/13%/19%.
Considering David’s a 30-something mid-career, this is a relatively balanced portfolio and it would probably be considered ‘conservative’ and some observations can be done:
- The exposure to stocks at 36% could be higher and the allocation to cash at 19% could be lower. David could for example increase his potential return by investing some of his cash into stocks. Or maybe David needs a lot of cash on hand because his spend is high and his Savings Rate is low?
- Even though David’s house represents the largest account in his portfolio at 31% of the total, the dominating asset class remains Stocks at 36% because he is invested in stocks through 4 of his accounts. If David’s company matches his contributions in his 401k, he might increase his stock exposure quicker than he increases his real-estate exposure. In a few years, a rebalancing might be necessary to not be overweight stocks.
- While David’s allocation is diversified and his company stock represents only 9% of his total, it represents a quarter of his stocks exposure (9%/36%). Regardless of the level of diversification he can have in his portfolio, 25% of his stocks holding are in 1 stock, the stock of the company that gives him his paycheck. It might be fine, but this shouldn’t be ignored.
Another very important point is that David has a lot of cash with 60k$.
David should create a dedicate account that will be his Emergency Fund where he will park the equivalent of 6-12 months of living expenses in cash. This fund is the ‘just in case’ cushion that will allow David to never be forced to sell parts of his investments to meet a cash demand. Once this fund is created, the excess of cash should then be invested in the other instruments available in his portfolio. The Emergency Fund should be labeled as such, be left untouched and be excluded from any asset allocation calculation since it does not qualify as an investment, but rather a safety net.
The Emergency Fund is cash only and should always be excluded from the Asset Allocation calculation because it is NOT an investment.
This X-ray analysis of David’s accounts allows him to understand where his money is currently invested in, how diversified his finances really are and where his allocation is potentially overweight already. There are no good or bad allocation, it depends on each individual’s expectations, risk tolerance and time-horizon.
However, if a windfall comes his way, or if David decides to implement an automatic investment strategy, this gives him some insight on the areas that might need more focus than others.
Readers, have you followed David’s steps and calculated your current Asset Allocation? Have you been surprised by some of the results? What have you done to address them?