Money 102: Asset Allocation
Submitted by SharpMan Editorial Team on Sunday 10th October 2010- Why is asset allocation important?
- What is an "asset class" suitable for allocation?
- How do I determine my asset allocation?
If you missed Money 101, check it out for an explanation of time horizons and risk tolerance. Once you have these concepts nailed down, you can focus on asset allocation.
What is asset allocation?
Asset allocation is the way your investments are divided (or "diversified") between different classes of investments, i.e. stocks, bonds, real estate, or cash. Studies have shown that proper asset allocation normally accounts for around 90% of the total return on your investment. In other words, your decision on how to allocate your investment dollars between general types of investments is much more important than selecting any one hot stock or mutual fund. That is, of course, only if you accurately assess your "risk tolerance" and stick with your investment plan when one asset class performs poorly. The old maxim is to buy low and sell high, not to buy high, sell at the first sign of trouble, and then buy again even higher. So the most successful investors allocate their investment dollars among several types of assets, invest regularly, and stick with the plan. For more information on identifying your "risk tolerance," see Money 101.
What exactly is an "asset class"?
Several types of "classes" are defined below:
Stocks. When you buy a share of stock in a company, you "own" an infinitesimal part of the issuing company. You then share in the company’s profits or losses. You may be paid in dividends, or you may take profits or losses when the price of the shares is raised or lowered and you choose to sell. Keep in mind that stocks aren’t guaranteed to go up every year, and may in fact lose value or remain stagnant for several years at a time.
Bonds. Bonds are basically IOUs. You lend money to, for example, the U.S. government, and they agree to pay you a certain interest rate, as well as the face value when the bond matures. Generally, bonds are considered "safer" than stocks (but watch out for interest rate changes), but their returns are generally not as high.
Cash. Cash is … well … cash: savings accounts, CDs, money market funds. You should keep at least a small percentage of your portfolio in cash for emergencies — keep more in cash if you have a major planned expense coming up in the near future. That way, you won’t have to sell your stock on the day it happens to drop 20%.
Why do you need cash? Well, is your job completely stable? How large are the deductibles and co-pays on your health care plan? If you think of all the tech companies that are currently dropping like flies, you’ll realize that it’s smart to set aside several months of living expenses in cash. Eventually this might make up 5-10% of your portfolio — even if you have a long time horizon and are very risk tolerant.
Real estate. Another way to diversify is to buy real estate. Don’t really want your own office building? Check out REITs (pronounced "reets"), which are real estate investment trusts. Investors combine capital and buy real estate via professional managers.
Mutual funds. Trick question — a mutual fund is not an asset class. It’s a way to pool your money with other investors to invest in one, or more, of the other asset classes defined above.
How do I determine my asset allocation?
There are a lot of theories about how you should diversify your portfolio, many of which are pushed by people who want to sell you something. In the end, your "best" asset allocation turns largely on the two questions raised in Money 101: what is your time horizon (when will you need the money) and what is your tolerance for risk (losses)?
With those questions in mind, there are two general tendencies you can use to help determine your "best" asset allocation mix:
Tendency One. A short time horizon means you invest a lot, if not all, in cash or short-term bonds. Period. You don’t want the rent money in a small Internet startup stock the day before the rent is due. People who need to start spending their retirement investments often carry a larger percentage of short-term bonds and cash.
Tendency Two. A longer time horizon (at least five or more years) equals adding at least some stock to your investment mix. Over time, this "riskier" investment tends to have a higher return (to reward you for taking more risk), while "safer" investments (like short-term bonds) tend to return much less, and may actually lose value when inflation (price increases in stuff you’ll eventually want to buy) is considered.
The amount of stock that you add to the mix depends, in large measure, on your tolerance for risk and your definition of a "long" time horizon. If you really don’t need the money for ten or more years, many planners recommend 80% - 100% in stocks with the rest in bonds or real estate. (And don’t forget your emergency cash reserve.) Of course, that’s only if you can tolerate, or ignore, the short-terms ups and downs of the stocks.
A more conservative investor with a long time horizon who has trouble "tuning out" short-term losses might go with 50% in stocks and 50% in bonds/real estate. In mutual fund jargon, this would be called a "balanced" portfolio.
A really conservative long-term investor will still need some stocks (20%-30%) in the mix to boost performance, with the remainder in bonds and real estate. In this case, the stock actually makes the portfolio less risky, since it will be more likely to stay ahead of inflation.
This article last updated on Sunday 10th October 2010