Investing Specialists

A Primordial Take on Asset Allocation

Christine Benz

What comes to mind when you hear the words asset allocation? Stocks, bonds, and cash, right? Maybe commodities, real estate, and a dash of precious metals thrown in for good measure. Perhaps alternative investments for those who are so inclined.

Those are certainly the main assets in the conventional asset allocator's toolkit. But I think investors spend too much time on this type of asset allocation--and the smaller-bore issues that follow from it, such as selecting specific funds, ETFs, and stocks--while ignoring even more basic asset-allocation issues.

What do I mean by more basic--so basic that they're downright primordial--asset-allocation issues? I'm talking about really big-picture allocations, like how you how you allocate your financial assets across your total opportunity set: spending versus saving, investing versus debt pay-down. Whether you've invested enough in yourself and maximizing your human capital. How you spend your money, and your time, too.

My cynical guess is that because most players in the financial services industry don't receive remuneration based on consultation in areas that don't relate directly to investments, they tend to not spend a lot of time talking about them. But you certainly should, because in the end, the decisions you make on these big-picture asset allocation questions will define whether you find success in life, and not just the financial kind.

Here are the components of your "primordial" asset allocation.

Your Saving versus Spending Allocation
It's hard to argue that any other allocation is more important to the success or failure of a financial plan than how much of your paycheck you spend and how much you save for later. So why is that so many investors who are scrupulous about various aspects of portfolio management--their asset allocations and fund expense ratios, for example--are loosey goosey when it comes to their savings rates? Most people undersave, unfortunately, but I've also encountered a healthy contingent of drastic underspenders, especially among older folks.

One possible explanation is that it can be devilishly hard to figure out how much you'll actually need, especially for the ultralong-term goal of retirement: You don't know how long you'll live, for one thing, or what market returns will be over your time horizon. Yet there are still some ways to put a finer point on whether your savings rate is adequate. Seeking guidance from a holistic financial planner is the gold standard. A good planner can help you quantify your goals, taking into account anticipated lifestyle changes in retirement as well as external assets like pensions and Social Security, and will practice tough love if you're not on track with your savings rate. DIYers, meanwhile, can avail themselves of a combination of tools and benchmarks. Fidelity's savings targets provide a quick view of savings adequacy for various life stages. Online calculators such as T. Rowe Price's Retirement Income Calculator can also help you gauge the adequacy of your savings rate given your expected income needs in retirement. If it looks like your savings rate has been inadequate to date, don't beat yourself up. Life is expensive, especially if you're raising kids and paying for college. On this front, I especially like financial planning guru Michael Kitces' advice to empty nesters; his research suggests that once college is out of the way and kids are out of the house, late-career accumulators have the potential to turbocharge their retirement savings.

Your Spending Allocation
Whether you're thinking about it or not, you're also making important decisions within the spending slice of your household finances. How are you apportioning your money across short- versus long-term expenditures? Are you prioritizing spending on stuff or on experiences? Does that $55,000 SUV bring as much joy as you would get from a more modest vehicle, if the lesser ride afforded you the opportunity to take your family on several amazing trips as well? Would you be better off steering your monthly gym membership dues to putting in a home gym that you might actually use?

Of course, these are really personal decisions; I can't say that any one set of spending priorities will work for every household. Maybe you really do need that expensive SUV or daily $6 coffee beverage to feel OK; I'm not here to judge. My point is to be mindful about the choices you're making, and if you can find spots to economize without hurting your quality of life too much, take advantage of them. I also like to remember the words of my dear mom when I'm tempted to keep up with the Joneses: "People think about you much less than you might imagine, dear. You're lucky if they think about you for 30 seconds."

Your Household Capital Allocation
This is another allocation decision that's way underdiscussed in financial circles. Assuming an investor has a finite set of funds to direct in a given month or year--and that's the case with all of us--how much of that amount should go to investing versus debt pay-down? Many households wing it on this front, but they could actually put a little bit of math into the decision-making.

Debt paydown, after all, promises a guaranteed return that's equal to whatever interest rate you're paying (less any tax breaks you receive for maintaining the debt, such as a mortgage interest deduction). That makes it fairly easy to calculate the return on investment of money steered toward paying down loans. Without a crystal ball, determining a return on investment for investing is more difficult, though the historic returns for various asset classes are a good starting point when calculating your portfolio's expected return. (Today I'd probably 1% for cash, 2% to 3% for bonds, and something like 5% or 6% for stocks.)

Armed with some numbers on the expected return on your debt paydown versus investing in the market, you can then make well-founded decisions about how to allocate your capital. High-interest revolving credit card debt? Easy--pay it off, as it's impossible to out-earn that guaranteed rate with any type of investment. Many other types of interest are on the bubble--student loan debt and mortgage interest, for example. It's also worth noting that debt pay-down doesn't provide liquidity, obviously, so if you are going to need the money any time soon, it's not an appropriate strategy.

Your Allocation to Investment Vehicles
This one gets a bit closer to the topics we often cover on Morningstar.com. Assuming you've decided to invest a certain dollar amount each month or each year, which vehicles are you employing? Are you investing within an IRA, 401(k), or taxable account? And if you're employing the former two vehicles, have you opted for Roth or traditional contributions?

There are a lot of considerations in the mix: investment choices (advantage IRA), tax treatment (advantage tax-sheltered vehicles, whether IRAs or 401(k)s), and your need for liquidity (advantage taxable account), to name but a few. There's also the question of whether you need discipline and guardrails: Company retirement plans, despite their faults, automate your investment program and constrain you to a list of usually sane choices, features you won't get with an IRA or taxable brokerage account.

There's no single right answer about where to invest your money. Tax diversification, like diversification across various asset classes and investments, is a valuable concept. And affluent investors will most certainly want to employ several different vehicles for their investments, both tax-sheltered and not.

Your Human-Capital Allocation
Our human capital--the earnings power of our skills, education, and experience--is the most valuable asset that most of us will have in our lifetimes. Are you using yours in a way that maximizes your returns over your lifetime?

Investing in human capital--via additional education or training--is close to a slam-dunk deployment of funds for early-career accumulators. If you can increase your earnings power with such an investment, you have a long time until retirement to benefit from it. The calculus isn't as simple as you get older; lifetime earnings may not offset the outlay of money and time for costly training later in life. Yet mid- and late-career accumulators should still make an ongoing investment in their own human capital--taking advantage of continuing education programs and conferences to enhance their skills, networking, and simply staying current on the latest news and developments in their fields. And no matter your life stage, staying current on the latest major technology developments, both on and off the job, is a crucial way to ensure that you stay relevant.

Your Time-on-Earth Allocation
Squishier, but even more important than all of the above: How are you allocating your precious time? Have you found the right balance of activities that make money, bring you joy, and do some good in this world? Better yet, can you find an occupation that balances all three in a way that's agreeable to you? I can't say I'm an expert on this, but this is the mother of all allocation decisions. It deserves frequent monitoring.