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Asset Allocation
Asset Allocation
What is
the most important thing an investor can do?
Practice Asset Allocation!
Here's
how it’s done:
Many investors spend sleepless nights worrying about which stocks to
buy and which to sell, which funds to own and which to dump, whether to
get into junk bonds, and whether IPOs are too risky.
What
is asset allocation? Simply put, this means the proportions of your
liquid assets that you put into different asset classes. Unless you're
a professional real estate speculator, the money you put into real
estate i.e., your home isn't included in this scheme. Rather,
investment allocation typically comes down to three categories: stocks,
bonds and money markets.
Studies have shown that asset allocation is the single greatest
determinant of investment performance. Perhaps unaware of these
findings, many investors blithely sink money into this and that without
ever formulating, much less following, an investment-allocation plan.
If they were to see a qualified financial advisor, however, they might
act differently, as drawing up an asset-allocation model is the first
thing many advisors recommend after getting a handle on clients' assets.
Things
to know about asset allocation
1. Hopefully 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. 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.
2. Education funds into stocks, if you have 5 plus
years!
If you're investing for your kids' education, you may want to consider
putting a greater percentage into stocks than you put into your
retirement investments.
3. Get professional advice, if you feel unsure.
You can develop an effective asset allocation plan working with a
qualified financial planner.
4. Asset 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.
5. Stock funds, know them like the back of your
hand!
Before you set up your asset allocation plan, you must find out the
nature of the companies purchased by the mutual funds you own.
6. Getting to know your bond funds.
Similarly, you must learn the same about the bond funds you own.
7. Get started today!
It's never too late to revise your asset-allocation plan.
What
is asset allocation anyway?
Once you've amassed two nickels to rub together, it's a
good idea to keep them in separate pockets and also, not in the same
pants.
Asset allocation is all about not putting your eggs
in one basket.
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Asset Allocation
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. Imagine that you have
all of your liquid assets invested in the stock market. Then
imagine that something were to happen to the very foundation
of this market. |
For example, millions of investors could
suddenly decide that tech stocks are greatly overpriced relative to the
returns shareholders are getting. So they all sell and few buy.
Depending on what your holdings are and how they're affected, this
could leave you hurting, indeed.
So you put your money into bonds. 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.
Moreover, a bad year in the stock market at the end of the millennium
may show up as nothing more than an insignificant blip by 2010 or
certainly by 2020. This is because the stock market is historically the
best long-term investment vehicle! One that can deliver an average
return of more than 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 closer to retirement age,
should put less money into the stock market than younger, less
risk-averse individuals. And invest a significantly greater percentage
in bonds.
An individual's risk tolerance and goals for returns on his or her
investments are dominant factors influencing what percentage of his or
her investment dollar should be put into each of the three investment
categories, and the specific types of issues that should be bought in
each category. Making these choices wisely delivers the maximum return
within each investor's comfort zone for risk, enabling him or her to
reach realistic financial goals without losing sleep.
Finding
a comfortable mix for your Asset Allocation
Your goals, risk tolerance and time horizon are the key.
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 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!
An
individual planning to retire in 15 years who has a high tolerance for
volatility may want to have 70 percent of his or her holdings in the
stock market, 28 percent in bonds, and 2 percent in money markets. If
this person is planning to retire in 25 years, he or she might ratchet
the securities holdings up to 80 percent.
Those retiring in 15 years but with less stomach for volatility may
want to keep 50 percent in stocks and 38 percent in bonds. For equally
volatility-shy people 10 years younger, the percentage in stocks could
be around 65 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 the
retirement kitty drastically short.
Individuals this close to retirement who can live with higher
volatility may want to put all of their holding’s in stocks, weighted
mainly in large-cap issues that are more dependable in the medium term
than smaller caps and internationals. Those who can't take as much heat
may want to put as much as 48 percent in bonds (principally
intermediate-term bonds), 2 percent in money markets and 50 percent in
stocks again, primarily large-cap stocks.
If your investment goal is putting your kids through college that is,
if you're using a separate pool of funds for this with a separate
asset-allocation plan, you may want to consider putting a bit more in
the stock market. For example, those with high volatility tolerance
might put 80 percent in stocks, while those who sleep more fitfully
might limit their securities investments to 65 percent or even less.
Achieving the right mix of stock types (small-, mid- and large-caps and
internationals) 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's comprised of, but what it actually is.
For example, some funds may call themselves small-cap. But, given the
less-than-stellar performance of small-cap stocks over the past year,
these same funds may have veered into large-cap territory to boost
their returns. Your fund's 800-number reps should be able to give you
information on this. If they can't, find another fund.
The need to determine what you already own is another reason to hire a
qualified financial advisor; he or she would have a good handle on most
funds. As your advisor 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.
Without this awareness, you could, for example, labor under the
assumption that your stocks are diversified across companies by size,
when, in fact, every dime you have in securities is in large caps.
Moreover, you should know what types of stocks your fund is buying by
sector. If your fund is tech-heavy, that's okay, as long as you don't
have too much in this fund and are sufficiently diversified with stocks
from more traditional manufacturing concerns, which tend to rise when
techs fall.
Similarly, don't take your short-term bond fund's word that its
holdings are all short-term. Find out what they think is short-term,
mid-term and long-term, and determine what they actually own. Moreover,
check out their credit criteria. Are they strictly into top drawer
AAA's? Or are they dabbling far lower on the pecking order by exploring
newly popular junk bonds?
Using
bells, whistles to optimizer your Asset Allocation
A successful asset allocation, is it an art or science?
This
debate has increased in intensity over the years as some planners have
sought to objectify asset allocation to the point where conceptual
thinking and judgment are de-emphasized.
The latest manifestation of this movement is the myriad variations of
software sold to do the job that financial advisors have been doing for
decades with pencils and calculators. Now, some planners and financial
services firms are using software programs called "optimizers" to
configure clients' allocations.
Though there's nothing wrong with using software to take the numerical
drudgery out of the task, these optimizers pose a problem: They lend an
air of scientific certainty to a task that necessarily involves the
subjective. If asset allocation were indeed a pure science, then most
or all optimizers would render the same configuration when fed data
about the same investor. But they don't. Optimizer results tend to vary
widely, and the slightest change in input data can yield greatly
disproportionate results.
Regardless of whether you use a financial planner's experience or a
newfangled optimizer to develop your asset-allocation plan, the process
will involve judgments. With the optimizer, the judgments have been
incorporated into the programs, often without the flexibility to deal
with the myriad shades of difference between one investor's situation
and another's.
And just as the style of financial management will vary from one
advisor to the next, so too will the styles of the professionals who
develop optimizers. If anything, optimizers are a standardized solution
to a problem that is anything but standard. The matrix of possible
asset allocations is virtually infinite, but there are only so many
optimizers on the market, and each has only so many variables to choose
from.
Instead of using pseudo-science, look for experience and training in
your advisor. If you're thinking of developing your asset allocation
without professional assistance, be prepared to do a lot of reading,
even if you're a highly knowledgeable amateur investor. And be prepared
to make some costly mistakes, literally!
Asset Allocation
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