Wednesday, July 30, 2008

Asset Allocation - What's That?

You may have had someone tell you, at some point or another, that 90% of the return on your investments comes from asset allocation. Asset allocation? What’s that?

Each investor has a different time frame, as well as a varying appetite for risk (and thus reward). Some people need their money in a few years, while others have decades to ride the markets. Some investors freak when they lose 5, 10, or 20%, while others ride on without being too phased by losses. While these investors have very different profiles, they all need one important strategy: asset allocation.

Asset allocation is, in Everyman’s terms, the way that you divide your investments between various categories of equities, fixed income products, and cash. Taking time horizon, risk tolerance, and other factors into consideration, this breakdown of funds can look very different from person to the next.

Example: Two investors with two very different asset allocations:
1. 23-year-old that understands that he’s in it for the long run and could almost not care less about short-term gains/losses.
2. 52-year-old that would like to retire next year, living off of her investment income, among other sources.

By diversifying their portfolios, each of these investors can buffer themselves against sever market fluctuations. However, the 23-year-old is still much more likely to have a higher risk profile – but will have at least 30 years to make up those losses. If the 52-year-old, however, had the same investments as the 23-year-old and lost 20% of the value of her portfolio, she may have to postpone retirement or live on less than she was expecting to be able to have available for her needs.

Reiterating, the two main determining factors in asset allocation are:
1. Time (horizon)
2. Tolerance (to risk)

If you have the time to make up your losses on some bad years, as well as the stomach to swallow those losses in the pursuit of larger gains, you’ll be more heavily invested in investments that have higher standard deviations of returns (but historically higher average returns as well).

Here is what their sample portfolios might consist of:

23-year-old – Aggressive Growth Portfolio
Category - % of Portfolio
International Equity - 25
Large Cap Value - 21
Large Cap Growth - 17
Mid Cap - 14
Small Cap - 12
REITs - 6
Emerging Market Equity - 5
Short-Term Bond - 0
Aggregate Bond - 0
Cash - 0
High Yield Bond - 0
International Bond - 0

As you can see, the entire portfolio is invested in equities. This would represent a very risky, yet potentially high-reward portfolio. This portfolio is likely to see both large gains and significant losses. Given a large number of years, however, it is likely to have a higher return than the next portfolio.

52-year-old – Conservative Income Portfolio
Category - % of Portfolio
Short-Term Bond - 35
Aggregate Bond - 25
Cash - 10
Large Cap Value - 8
High Yield Bond - 5
International Bond - 5
International Equity - 5
Large Cap Growth - 5
Mid Cap - 2
Small Cap - 0
Emerging Market Equity - 0
REITs - 0

This portfolio have very little exposure to the equity markets and is almost entirely in fixed income and cash. This makes sense, as both fixed income and cash have smaller standard deviations of their returns (and thus, are more predictable in determining what the return will be on the investment).

These two portfolios are more on the extreme edges of the spectrum. The majority of you will fall somewhere in between these two, with a balanced mix of equities, bonds, and cash. Generally, the closer you are to retirement (time horizon) and the more sensitive you are to short term losses (risk tolerance), the more you’ll be invested in bonds rather than equities.

Overtime, both of these two hypothetical investors will want to rebalance their investment portfolios to move them back to their original allocation percentages. This, in theory, also helps investors by forcing them to capture gains (if large cap growth did really well, it may now be at 25% of your holdings instead of the original 17%), as well as purchase securities when they are “cheap”(if small caps had an off year, you need to buy more to get it back up to its original allocation). This follows the basic (yet so psychologically difficult) premise of buying low and selling high. Too often, we tend to buy the “hot” option at the time, only to find out that we missed out on most of the growth and instead have most likely jumped on just before it comes back to normal (thus, a loss for you, Mr. Late to the Party!).

Smart investors use asset allocation strategies. So should you, the Everyman!

To find out what percentage of your money you should have in each category, try out a couple of these helpful tools online:

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