Asset Allocation Overview
What Is Asset Allocation?
Asset
allocation is the process of aligning your risk tolerance, financial
objectives and investment time horizon to your investment portfolio.
Selecting different asset types (commonly known as asset classes) may
reduce the risk of your overall investment portfolio.
The three most common asset classes are:
- Cash or Short-Term Investments (savings accounts, money markets, etc.)
- Fixed Income Investments (bonds)
- Equities (domestic and foreign stock, etc.)
Each
of these three asset classes can be further subdivided. For example,
equities may be broken down by size (small, medium or large capitalized
companies), different sectors of the economy (technology, financial
services, etc.) or be divided geographically (U.S., Europe, Asia, etc.).
The
decision of how to allocate your investments depends on a number of
factors including your investment objectives, time horizon, attitudes
toward acceptable risk, desired return and tax bracket.
The basic
premise of asset allocation is this -- by diversifying your investments
over a number of different assets and asset classes, you can reduce the
risk of the entire portfolio while maintaining your desired long-term
return rate expectations. Over the long term, an appropriate asset
allocation (what to buy) is more important than when to buy. Generally,
a decline in one asset class can be offset by an increase in another.
Your choice of individual investments can also reduce the risk of your
portfolio. For example, if you diversify within each asset class and
choose a number of stocks across different industries, your technology
stock may be declining while your financial services stock may be
rising. This strategy can also help reduce overall portfolio risk as
opposed to investing in all of your stocks in a single company or
sector of the economy. Studies have shown selection of a portfolio’s
asset allocation can be responsible for over 90% of a portfolio’s
performance with market timing, security selection and other factors
contributing the remaining portion.1
Does Higher Risk Equal Higher Potential Return?
Your
overall comfort level with risk should be a major factor in choosing
appropriate investments. It is important to consider that generally,
achieving a higher rate of return requires accepting a higher level of
risk. Higher risk investments are generally appropriate for clients
with more aggressive risk profiles and longer investment time horizons.
If your financial objective is many years away (retirement, for
example) your investments may withstand the ups and downs of the
market. If your goal is only a few years away (such as the purchase of
a new car), your investment may decline during the period you wish to
redeem the investments. Generally, as your financial goal approaches,
you should reduce the risk of your investments by reallocating to a
less aggressive asset mix.
Why Should You Consider Inflation?
When
planning for an accumulation goal, (retirement, education, or a major
purchase) consider the effect of inflation on the eventual cost of the
item. If inflation is not considered, savings may fall short of your
goal. For example, an item that costs $1,000 today will cost $1,344 in
10 years, assuming a 3% inflation rate.
Rebalancing Your Portfolio
Market
activity may cause one asset class to become a greater percentage of
the portfolio. Periodic rebalancing helps ensure that your portfolio
continues to reflect your desired target asset allocation. Rebalancing
ensures that you do not end up overexposed in one type of investment or
asset class.
Rebalancing should be done at regular intervals far
enough apart to avoid adjustments based on short-term fluctuations.
Reviews should be done frequently enough to keep on track, usually
annually.
Mutual Funds and Asset Allocation
Because there
are so many different types of mutual funds, it is common for investors
to use mutual funds to achieve their recommended asset allocation. For
example, an investor in the Boomer Pre-retirement stage, might create the following mutual fund portfolio:
- 12% Intermediate Bond Fund
- 12% Long-Term Bond Fund
- 26% Short-Term Government Bond Fund
- 24% Large-Cap Growth
- 6% Large-Cap Value
- 10% Mid-Cap
1Brinson, Hood and Beebower, “Determinants of Portfolio Performance,” Financial Analyst Journal, May-June 1991.