Asset Allocation

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Asset Allocation...

I've been thinking about asset allocation and came across this very interesting article by Tom Olson from the The Asset Advisor. It seems that the common mistake many people are making in their diversification is buying stocks from the same industry or in similar industries and considering themselves diversified. If you buy all tech stocks, you may be setting yourself up failure. Below is the article:



Asset allocation is a critical component of investing success. Both research and academic studies show asset allocation to be single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio. Other factors such as security selection and market timing account for a very small percentage of your investment returns. Unfortunately, the most important decision to achieving financial success is also the least understood.

What is asset allocation? Most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments among groups of similar assets. Ask investors to list the assets in which they would consider investing. Typical answers include "growth stocks", "bonds", "large caps", and sometimes "international stocks." But their diversification is limited to selection within one asset. For example, someone choosing to purchase technology stocks may invest in five or six companies - but all within the technology industry. This reduces risk if one of the companies should fail, but is useless when the technology industry (or entire stock market) slumps.

Asset allocation goes beyond diversification to reduce risk across all type of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Investments and risk can be divided further into subcategories of stocks including large-cap, mid-cap, small-cap, value vs. growth, and international vs. domestic. Similarly, bonds can be divided into subcategories of short-term, and long-term, tax-free, high yield, convertible, emerging markets, floating rate, and international vs. domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even opposite to each other, both increases the return and lowers the risk of an entire portfolio. For example, international stocks are considered "riskier" than domestic stocks. Yet, we often see the prices of U.S. stocks go up on the same day prices of international stocks go down — and vice versa. We call this negative correlation. Profits from one asset balance the losses from another. Combining international and U.S. stocks actually lowers investment risk by reducing daily price swings of our entire portfolio.

History demonstrates many markets exhibit similar negative price correlation. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents risk to any investor. Choosing to purchase only stocks, only bonds, or any single asset class increases the risk of losing money if that market underperforms.

The power of asset allocation comes from reducing risk while increasing returns. Reducing risk by combining multiple asset classes, however, is not a simple process. While each asset has its own unique measure of risk, many assets share similar price behavior (their prices go up and down together in any market). Combining such complimentary investments increase the risk of wild changes in price. Trade-offs between asset risk and expected return must also be considered. High yield assets typically experience high volatility, or large changes in price. These assets must be balanced by investments with lower rates of return to protect against large declines in value.

Successful asset allocation requires finding the proper mix of assets to balance reward with an acceptable level of risk. Proper allocation planning requires asset research and investment analysis. Fortunately, tools are available to assist the independent investor. Popular financial websites offers independent investors help with educational links and software to build portfolio allocations based on a survey of financial questions. For advanced investors, many books have been written to painstakingly explain the theory and practice of asset allocation - also called MPT (Modern Portfolio Theory). Casual investors can purchase mutual funds specifically designed to automate asset allocation based on an expected retirement date. Pragmatic investors can explore the many financial planners and advisory services that offer asset allocation portfolios specific to their needs.

Consider your options carefully. Each solution offers its own set of advantages and disadvantages. Pick a style that closely reflects your own. Just how important is asset allocation? It's the single largest determinant of your long-term financial success.

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What is asset allocation anyway?
Got two nickels to rub together? Keep them in separate pockets.

Asset allocation is about not putting all your eggs in one basket. It's the ultimate protection should things go wrong in one investment class or sector, as is likely to be the case from time to time.

For example, many people loaded up on technology stocks in the late 1990s. When the market corrected in 2000, many of these investors experienced steep losses.

Or, you may put your money into bonds, among the safest of investments. Yet the bond market, too, has its up and down swings. Disgusted with that market, you put your money in a money market account. However, though virtually bomb proof, this market provides far lower returns. After all, less risk means lower rewards. And even modest inflation steadily erodes the value of your cash.

Moreover, a bad year in the stock market may show up as nothing more than an insignificant blip by 2015 or certainly by 2025. This is because the stock market is historically the best long-term investment vehicle - one that can deliver an average return of roughly 10 percent annually for those willing to stick it out for the long haul.

In the short term, however, the stock market is more volatile than other investments. Consequently, investors with less risk tolerance - and this generally includes people who are close to retirement age - should put less money into the stock market and invest more in bonds. Younger people, however, can take on more risk because they have a longer investing horizon.

Your risk tolerance and goals will determine how much you put into each of the three investment categories. If you make careful choices with your asset allocation, you'll earn better returns without losing sleep.

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Finding the right mix
Identify your goals early and know your threshold for volatility.


The ultimate financial goal, of course, is retirement. How soon you retire - and in what style - can be greatly affected by your decisions on asset allocation made earlier in life. In accounting for risk in your asset allocation, it's more productive to think in terms of your tolerance for volatility.

This is because one of the greatest investment risks is the risk of doing nothing - and missing out on superior returns.

Those retiring in 15 years but with little tolerance for wild swings may want to keep 50 percent in stocks and 40 percent in bonds, with 10 percent in a money market account.

If this person is planning to retire in 25 years, he or she might ratchet the equities holdings up to between 70 and 80 percent.

Those retiring in five years are faced with the daunting task of allocating their assets for maximum return without betting the farm. A nasty market dip could occur immediately before retirement, leaving your nest egg drastically short.

Achieving the right mix of stock types (small-, mid-, and large-caps) and bonds (short-, medium-, and long-term) to achieve maximum return for your volatility tolerance while maintaining adequate diversification is a tricky business, so you may want to consider consulting a qualified financial planner or adviser.

Before you actually invest in accordance with your newly minted allocation plan, you will want to do something that few individual investors do: Find out specifically what you own.

Most people don't know precisely what they own because their portfolios are dominated by an accumulation of mutual funds. If you strip away the marketing veneer of each fund and do some investigating, you can not only find out what the fund says it invests in, but also what it actually owns.

For example, some funds may call themselves small-cap. But, these same funds may veer into large-cap territory to boost their returns if their sector is out of favor. Your fund's 800-number reps should be able to give you information on this.

The need to determine what you already own is another reason to hire a qualified financial adviser; he or she would have a good handle on most funds. As your adviser would tell you, you must break these funds into their component parts to know what percentage of your assets is in small caps versus large, or in long-term bonds versus short-term.

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Bells and whistles
Is successful asset allocation art or science?


There's been debate in recent years about the value of software programs in building an asset allocation plan.

Though there's nothing wrong with using software to take the numerical drudgery out of the task, these programs pose a problem: They lend an air of scientific certainty to a task that involves the subjective.

If asset allocation were really a pure science, then all programs would deliver the same results when fed data about the same investor. But they don't. The results vary widely.

The process of building an asset allocation plan involves judgments, and there is no such thing as a standardized solution. The matrix of possible asset allocations is virtually infinite, depending on your situation. The most important point to remember is that successful asset allocation depends on personal variables, such as one's age, risk profile, etc.

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Top things to know...

1. Time is on your side.

Those with more years until retirement can afford to put a greater percentage of their assets in the stock market.

2. Stocks mean risk and return.

Those with a higher tolerance for volatility should put more money in the stock market than those in the same age group who have a lower tolerance.

3. College savings funds need stocks.

Since college costs are rising faster than inflation, no other investment will keep pace as well as stocks. Invest more in stocks when your kids are young, and as they get older move more money into bonds.

4. Get professional advice.

One of the best ways to develop an effective asset allocation plan is to consult a qualified financial planner.

5. Allocation is the key to achieving your goals.

Studies have shown that asset allocation is the single most important factor in determining returns from investing.

6. Know your stock funds.

Before you set up your asset allocation plan, you must find out the nature of the companies purchased by the mutual funds you own. It's not enough to go by the names of the funds themselves, either. In search of performance, far too many fund managers buy stocks that barely fit their portfolio's explicit investing parameters. So your "income" fund may, in practice, contain many stocks that should be considered "growth," or vice versa.

7. Know your bond funds.

Similarly, you must learn the same about the bond funds you own.

8. Don't rely on software alone to build a savings plan.

Software programs might not go far enough to devise your asset-allocation plan.

9. Determine your long-term goals.

Do you want to buy a sailboat after you retire? Or pay off your mortgage so you can write a novel? Figure out what your long-term goals are, and what they will cost.

10. Get started.

It's never too late to get started, and it's never too late to revamp or revise an asset-allocation plan.