Focus on Fundamentals: Asset Allocation

The way you divide your investment dollars among stock, bond, and money market investments is known as asset allocation.1 As simple as this strategy sounds, it is deceptively powerful: Studies have found that asset allocation decisions account for more than 90% of your portfolio’s performance over time.2

As we near the end of the year, often a time of reflection, investors who haven’t reconsidered their asset allocation in a while may want to give it a fresh look. The following steps will help.

Come to Terms With Asset Allocation

First, be sure you have a handle on the concept of asset allocation, which is often confused with its sister strategy, diversification.3 Assume for a moment that you are assembling a portfolio from scratch. Before you select specific investments, you’ll need to decide what percentage of your money to put into each of the major asset classes (stocks, bonds, and money markets). That’s asset allocation: spreading your money among asset classes based on your goals, risk tolerance, and time horizon.

All portfolios start with a strategic, or default asset allocation. Your default allocation represents the mix of asset classes best suited to meet your goals over the long term. As a result, a default allocation tends to remain static over time until the individual’s investment objectives and/or risk tolerance change significantly. By comparison, a tactical asset allocation is adjusted regularly to reflect temporary leanings toward one asset class or another based on short-term market movements.

Once you have settled on a default asset allocation, it’s time to consider diversification.3 The premise is simple: Investing in a single company, sector, country, or even asset class can be exceptionally risky — your return will be dependent solely on that investment’s performance. To help reduce risk, you diversify, or spread your money among a variety of securities, creating the potential for top performers to compensate for underperformers.

Review Your Asset Mix
Do you have an asset allocation plan in place? To understand why it is so important to have an asset allocation plan — and not just a random mix of investments — take a look at the chart below. Historically, different asset classes have resulted in different risk/return profiles. The question you have to ask about your current mix is, does the risk/return profile still fit your needs?

Decide Whether You Need a New Mix
Unfortunately answering that question is not as easy as picking a plot point on a chart. First, you’ll need a clearly defined goal — “enough money to retire” won’t cut it. Take the time to run some estimates using one of the many retirement planning calculators found online.

Then you will need to assess your risk tolerance. To do this you first need to understand the different types of risk: from market risk — the possibility that a security will fall in value as the broader market declines; to liquidity risk — the possibility that a security cannot be sold at a fair price within a particular time frame.

Next, consider your risk tolerance from two perspectives — financial and emotional. For instance, if the market were to decline by 5% in a day, could you handle that loss financially? And just as important, could you cope with it emotionally, or would you lose sleep? There are numerous surveys and worksheets designed to gauge both types of responses.

The third variable affecting your asset mix is your time horizon. Will you need the money you have invested in four years or 40? Your financial advisor can help you through each of these tasks and then work with you to decide how the information you come up with relates to your asset allocation.
If the two of you determine that your allocation is out of balance, you’ll have a couple of options: add new money to the asset class that is underrepresented in your portfolio or shift money from the overrepresented asset class to the others.

Keep an Eye on Your Asset Allocation
Finally, once you have a carefully crafted asset allocation, maintain it. Review it on at least an annual basis, making alterations as your investor profile changes. And rebalance the mix if the performance of one asset class throws it off kilter.

Source/Disclaimer:
1Investing in stocks involves risks, including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Asset allocation does not assure a profit or protect against a loss.

2Gary P. Brinson et al. “Determinants of Portfolio Performance,” Financial Analysts Journal, May/June 1991.

3There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

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Photo Credit: Angelo Greco