What is asset allocation? Asset allocation is exactly what it sounds like. It is determining how you are going to apportion your invested capital to manage risk and realize gains. Think pizza. You can get all pepperoni, or half pepperoni half sausage. How are you going to cut your investment pie? Asset allocation is merely exercising the age old adage of not putting all your eggs in one basket. The concept is the same.
As I have said before, your asset allocation should be based on your financial goals and where you are at in achieving those goals. For that reason I am not going to go too far into depth on what the appropriate percentages of various investment vehicles and/or asset classes are, although feel free to contact me if you want some free advice. Instead I am going to cover some simple, yet key concepts of what to consider when determining your asset allocation.
Risk - How much risk are you willing to take? Only you can answer this question. However, here are some things you might want to consider. First off, what are you investing this capital for? For instance if you are investing in a Roth IRA for your retirement, your risk tolerance may be lower than the risk you are willing to bear for the extra money you got back at tax season that you want to play with. Another thing you should consider is how quickly you need access to the capital. Someone who is close to retiring will be much less willing to incur risk than a 20 something saving for their retirement. Lastly you need to do a little gut check. How conducive is your personality and overall demeanor to dealing with risk? The goal is to keep putting money in, not panicking and constantly buying and selling.
Reward - What kind of return do you need to realize in order to achieve your financial goals? How long do you have to achieve those goals? Different asset classifications have different historical returns. Below is a chart showing some historical returns of various asset classes. The numbers may be a bit different from other sources due to different time periods and assumptions but the overall disparity between the classes is fairly indicative of most statistics.
Now that you have analyzed your goals and current situation you should have a decent idea of what type of risk/reward trade off you are willing to accept. Let's use my retirement portfolio as an example for some other things you should be thinking about. So I am 26 years old. Lets assume that I want more than a million dollars in my retirement by the time I am 65 (here is a retirement calculator you can play with that may help you determine how much return you need, how much you need to save, etc. to reach your goals). I know that I am fairly tolerant of risk and I have a long investment horizon to reach my goals. Why don't I just invest all in small cap US stocks? The answer is volatility. Although small cap US stocks may have a 12% return over a period of years it may have a -40% (probably this year!) in any given year. So what, isn't that just part of the risk you accept in the market? Yes, but what if half of your portfolio lost 40% and the other half was an asset class that gained 40%? You would be even. Or better yet what if the other half of your holdings gained 50%? You get the idea. This concept is called correlation. How correlated are the historical performances of your holdings? The goal is to reduce variation of return by diversifying your holdings to achieve a constant, steady, and most importantly greater return than if you did not diversify your assets. So in my case I know that I want to achieve the most return possible for a long term timeline. I will not be concerned with the day to day activities of the market, yet I want to be diversified enough so that a scenario much like the current market doesn't destroy me. Don't get me wrong, the current state of the economy has done some major damage to most people's portfolios including mine, however Mint.com is showing that my current asset allocation is outperforming the NASDAQ, S&P 500 and the Dow. The moral of the story is that it could be worse!
So my asset allocation will be distributed mostly amongst equities, a small portion of bonds, REIT's, and Precious Metals and Minerals funds. Within my equities I am diversified between foreign and domestic, as well as small, mid, and large cap stocks. I am trying to not get too in depth or too technical, because I am not writing a book here and there are plenty out there that do a better job than I do of explaining and recommending asset allocation models. The point is that you should be diversified appropriately based on your goals, risk/reward tolerance, and your timeline.
Here is an example of what an older person's asset allocation may look like. Since they have a much shorter time frame to retirement their goals and risk/reward tolerance will be much different than mine. And therefore their asset allocation looks much different as well. This person is likely concerned with preserving the capital they have while protecting it from inflation. Hence, the larger concentration of bonds and cash equivalents. The current state of the economy surely gave a rude awakening to many baby boomers on the lessons of asset allocation, as many of them who had large portions of their portfolio in stocks have lost significant amounts of their retirement.
Hopefully this post has served as a guide to know what you don't know. It is far from all encompassing but hopefully it gets the gears turning. If some of this is new to you don't feel bad, feel empowered and start educating yourself on the topic. I recommend reading "A Random Walk Down Wall Street" and "The Art of Portfolio Investing and Management: A Proven 6-Step Process to Meet Your Financial Goals" both of which are on my bookshelf on this blog. Once I re balance my Roth IRA and make my asset allocation excel sheet look pretty again I will post more in depth analysis of my portfolio. I would love to open up discussion and get tips from others as well. Keep checking in for more Money Tips posts, and if you are interested in writing a guest blog for my Guest Bloggage installment write me a comment or email me.
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