The Investment Series: Maximize Results with Asset Allocation

 Asset Allocation Basics (Go to the Investment Series for other Basics)

This is the fourth article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.

Importance 91.5%

Asset Allocation is the process of dividing your investment dollars among asset categories that generally behave differently in market cycles.

The independent investment firm of Ibbotson Associates ranks the importance of the three major determinants of portfolio performance as follows:

Asset allocation 91.5%
Security selection 6.7%
Market timing 1.7%

Asset allocation is the clear winner over time.

We've all heard of someone who bought one stock at the right time and made a lot of money. We may have dreamed of finding the next Microsoft or Cisco and retiring early in the style to which we'd like to be accustomed. The "one stock-hope to hit it big" strategy is for the gambler. Asset allocation is a prime strategy for the investor. Most gamblers will not succeed. Most savvy investors will.

 

Modern Portfolio Theory

Modern portfolio theory looks at the detailed historical behavior of different asset categories. In a given set of market conditions, some asset categories will outperform the market and others will underperform. Some category will always outperform. Modern portfolio theory uses complex mathematics to evaluate different combinations of categories to determine the best return for a given risk and time horizon. The risk can be quantified into a statistically accurate prediction of performance. Of course, there are no guarantees, but the investor can see the statistically predicted range of performance of the portfolio in dollars. The uncertainty decreases as the time horizon increases. So, in addition to being a powerful investment tool, asset allocation can provide performance predictions useful in personal financial planning.

Modern portfolio theory has been applied by institutional investors for years. Mutual funds coupled with modern computing power have opened the door for the smaller investor to benefit from sophisticated analysis as well. Mutual funds provide a vehicle for an individual investor to participate in diversified investments in specific asset categories. Modern computing power allows web sites and individual brokers to offer personalized asset allocations.

 

Did you know?

Between 1926 and 1998, stocks had 20 down years, bonds had 7, and Treasuries had none. During that period, the average annual return of stocks was 11%, bonds 5.25% and Treasuries 3.76% (Source: Retirement Advisors of America )

The Simplified Model

Many 401k plans have provided participants with a simplified "do it yourself" asset allocation model. The simplified model typically considers three asset categories:

  • Cash and low risk cash equivalents such as money market funds
  • Bonds
  • Stocks

Since the assumed goal of the 401k plan is retirement, the simplified model will use age as a primary input as well as asking for your risk tolerance. Your answers will result in a recommended allocation among the categories of cash, bonds, and stocks.

A more complete analysis will need to consider financial objectives other than retirement. For example, an entirely different allocation would be used for college savings for your high school freshman.

If you choose to use asset allocation as an investment tool, here are three things to review annually;

Review your investment goals and adjust your allocation to reflect changes in your objectives

Rebalance your portfolio to maintain your desired allocation. Market performance will likely be changing your asset balances.

Take a big picture look at performance and goals. Are you getting where you need to be? If not, you may need to make adjustments such as investing more, changing your risk level, or changing an objective. If you are ahead of your goals, you may have an opportunity to reduce risk. Getting greedy can change you from an investor to a gambler. A friend once said, "Pigs get rich, hogs get slaughtered."

Don't be a hog, be an investor.

Check back for the next installment in the Investor Series: International Investing. 

A partial list of asset categories:

Cash
Money market funds
Treasury bonds
Corporate bonds
Large cap growth stocks
Large cap value stocks
Small cap growth stocks
Small cap value stocks
International Developed Market
International Emerging Market
REIT's (Real Estate Investment trusts)

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