Understanding Asset Allocation
IBM or Yahoo? Amazon or Disney? Sell now or hold
out? Most investors devote a great deal of time to trying to pick the right
stocks or to attempting to time the market. That effort might be better spent by
concentrating on the allocation of funds among asset classes.
Importance Of Asset Allocation
Far too many investors underestimate the importance
of asset allocation, the process of systematically dividing your investment
dollars among different classes of investments. However, research conducted by
economists Harry Marcowitz and William Sharp, who won the 1990 Nobel Memorial
Prize for Economic Science, determined that asset allocation has, by far, the
most significant impact on the overall performance of investment portfolios. In
fact, research has shown that the allocation of assets among the three asset
classes typically accounts for more than 90 percent of investment return.
Surprisingly, an investor's ability to pick winning stocks, or to time the
market is, in comparison, of little significance.
Three Major Asset Classes
For the purpose of asset allocation, there are
three major asset classes — stocks, bonds, and cash. Stocks, which represent a
share of ownership in a business, are essential to long-term investment planning
because historically they increase in value. Traditionally, bonds have been seen
as fixed-income-producing investments because the interest they pay is typically
fixed. Bonds also play an important role in balancing movement in the stock
market and in providing a cushion against stock market volatility. Cash and cash
equivalents, such as U.S. Treasury bills and bank certificates of deposit, offer
safety and liquidity for money that might be needed within a relatively short
time frame. Since each of these three types of assets responds differently to
shifts in the economy and markets, spreading money among stocks, bonds, and cash
equivalents can help investors ride out market uncertainty.
Allocation and Diversification
The terms asset allocation and diversification are
commonly confused. While asset allocation refers to the different asset classes
(equity, bonds, and cash), diversification refers to the process of further
dividing your investment dollars within each of the three asset classes.
Allocating a portion of your investments in each asset class to appropriate
sub-categories can further reduce risk and enhance return.
For example, you might decide to achieve
diversification in the stock asset class by choosing both domestic and
international stocks. If you choose to invest in mutual funds, you might
diversify your holdings by investing in funds classified as “growth and
income,” “growth,” and “aggressive growth.” Similarly, you can achieve
diversity in your bond portfolio by selecting different types of bonds with
different maturity dates and by using bond mutual funds. With diversification,
setbacks in one investment can be offset by gains in another.
Proper Allocation
How you allocate your assets depends on a number of
factors including your financial goals, age, tolerance for risk, current and
long-term income needs, and even your tax situation. As you move through
different stages in your life, your best asset allocation scenario is likely to
change. For example, younger individuals with a longer time horizon should
invest a higher proportion in stocks — the best investment for growth.
An investment portfolio with 80 percent invested in
stocks, 10 percent in bonds, and 10 percent in cash might be appropriate for a
young investor. However, as you get closer to the time when you will need the
money you have invested, you should adopt a more conservative strategy and
gradually begin reducing the amount invested in stocks and increasing the
portion of your investment allocated to bonds and cash. This reallocation may
become particularly important as you approach retirement.
Rebalancing Your Portfolio
Over
time, as different asset classes’ increase or decrease in value with shifting
market conditions, the mix of assets in your portfolio may become inconsistent
with your planned asset allocation strategy. When that happens, you need to
reallocate or rebalance your assets to bring your portfolio back to the proper
allocation.
If one asset class has surpassed your planned
percentage, you should reinvest the proceeds in a class of assets that has under
performed. For example, if stock prices rise and your portfolio becomes weighed
toward stocks, you can return your portfolio to the right mix by selling some
stock and increasing your investment in bonds. This method has the added benefit
of forcing you to employ a "sell high, buy low" strategy as you take
profits out of assets where prices have gone up and reinvest that money in
assets that are cheap.
By
developing a successful asset allocation policy and monitoring it carefully, you
can reduce portfolio risk and improve the overall return of your portfolio over
time.