Asset allocation is a very popular word in the investment world. In fact, most asset managers and portfolio architects are spending most of their time and skills in finding the most optimal asset allocation for their client’s money.

Asset allocation is very important to diversify risk and get a better risk-adjusted return.

When you diversify across asset classes like stocks, bonds, real estate and alternatives, the overall risk of the portfolio goes down due to the uncorrelated nature of the chosen asset classes.

Of course, the correlation is also dynamic and highly dependent on other factors like geography, economic conditions, world affairs and human psychology in the markets.

Why is it relevant for personal finance?

All of us are looking for better returns of our money – whether we do it ourselves or hire an investment manager or firm.

This is the most traditional way of managing money. You have a pool of money that you want to invest, so you go to an investment firm or advisor and ask them to suggest a portfolio or invest it in your behalf.

The problem does not end there, it actually starts in this simplistic approach.

Most people I know do not stick to their investment philosophy or plan, even if they have hired the best advisor that they could afford.

Human biases in money and the need for control trumps every other logic.

When the markets are falling, investors call their brokers or login online to pull back their money. Similarly when markets are rising, euphoria sets in and investors frantically call their brokers to buy, buy, buy. Of course, the brokers have nothing to complain about, they make money through trades and commissions either way.

The advisor will also make money since he either charged you a flat fee for his advice, or charged you 1% of the AUM (assets under management).

Do you see the problem? We approach investments in the wrong way.

Enter Lifestyle allocation

The reason the above plan or strategy fails is that the investment is connected to the market or assets, and is subject to all kinds of volatility, noise, opinions – in short, external events and influences.

The above is Outside In, that is, you learn about investing from books, friends, family, media and then hire professional managers or do it yourself.

And then, the same Outside In factors ruin the plan as soon the economy takes a turn, a law changes or some country declares war.

What if you can take a completely opposite approach to investing?

I urge you to consider an Inside Out plan to your finances.

This is where you can start looking at two things – your life and your finances.

And connect the two – this is called Lifestyle Allocation.

The Lifestyle Allocation means that your finances are first connected to your life goals, and then to achieve each goal, you make the right investments.

It could mean more than one investment portfolio, but it is very effective since now each portfolio is tied to an intrinsic goal and not external factors.

True, the external factors will have an impact on the portfolio, but the goal will define what actions or how much bothered you need to be.

Also, it defines how much risk you can take, not measured by a generic risk profile (as most investment managers make you fill up), but by understanding the importance of the goals in your life.

The Lifestyle Allocation can be described in the following four steps.

• Financial Reboot – Taking a look at the state of your finances and what you have.
• Financial Plan – Defining your Lifestyle goals through a SMARTY plan.
• Financial Flow – Putting the plan into action by allocating money to each goal.
• Financial Growth – Now finding the right portfolio for each goal.

If you would like to read about these steps in detail and how they can apply to you:

When you design your lifestyle in this way and use your finances to fund the lifestyle, you have a much more meaningful allocation of your hard earned resources.

You will also find that some of the goals will have very simple and standard portfolios, and you do not need to hire an advisor/manager and pay for the AUM for these goals.

For example:

• The Emergency Fund is maintained in a High Yield Savings Account.
• The College Savings Fund is maintained in a 529 account with in-built portfolios.
• The Freedom Fund can be invested in one low cost index fund like the S&P 500.

For truly long term goals like retirement, you may need to consult a professional who can give you the right asset allocation, projections for different market scenarios etc.

Conclusion

Thus the best way to reduce risk in your financial life is to do a Lifestyle Allocation.

Lifestyle Allocation keeps you from making sub-optimal decisions and your emotions playing havoc with your money.