Investing - Part VII

Asset Allocation

Part seven of my four part series on investing is going to take a look at the idea of asset allocation. Asset allocation is the idea of dividing your investments between the three major investment categories so as to take advantage of each type of investment that is available to you.

There are really three main classes of investments: stocks, bonds and cash. Stocks represent ownership in a company. Bonds represent a debt that the company owes you. Cash is, of course, cash. So why would you want to have a little of each category in your portfolio?

Stocks, as evidenced by the bubble and its bursting since the late '90s, have great return potential, but also great risks associated with them. An all equity portfolio is really only for the extreme risk-taker, for someone who can stand to use 50% or more of their investment (yes, 50%).

Bonds on the other hand, are very conservative. They are designed to generate income and usually provide little in the way of capital gains. Not all bonds are completely safe, but an all-bond portfolio is one that would generally be considered conservative.

Cash is really a poor choice, as far as investing goes. Interest returns on cash are almost always much less than that available even through government bonds. An all cash portfolio is a great way to lose purchasing power over the long haul.

But what if, like me, you're neither ready for the investing X-Games nor are you ready for the absolute safety of an all T-Bond portfolio? What do you do then?

Most people actually fall somewhere in the middle ground. The first few questions you need to answer are: Why am I investing this money? How long will it be before I need it? How much am I willing to lose in 12 months? How much can I lose before it becomes impossible to sleep at night?

These questions will actually give you a pretty good idea as to your risk tolerance. Risk tolerance is essentially how much risk you are willing to take in order to have a decent return on your money.

People saving for a retirement thirty years out and who can stand losing 40-50% of their portfolio in a 12 month period will generally be able to take on a high degree of risk.

Folks saving for a new house in a few years or an imminent retirement, or that can't bear the idea of losing even 20% in a year, will probably be leaning towards a low risk portfolio.

Someone with immediate expenses on the horizon (in a year or less) will actually want to keep cash or an extremely conservative bond selection in their account.

But how do you adjust the risk of the overall portfolio, given just the choices of very risky stocks, very safe bonds, and rock solid cash? You allocate.

Let's take someone who is moderately aggressive. They're probably looking at 20-25 years before needing the money, but they don't want to take too much risk. Their portfolio, after discussing their wants and goals with their broker, will probably be somewhere between 50-70% stock, 25-40% bonds, and the balance in cash. This will give them the growth potential of the stock, while still maintaining a stabilizing influence from the bonds and also being ready for unforeseen opportunity or problems by keeping a cash position.

Over the long term (measured usually over a span of 15-25 years - this is real long term investing), their portfolio will probably average between 9 and 11% annualized returns.

9 to 11%? After the years in which making 30% or more was impossible not to achieve? Yep. The average return of the stock market since the 1930s has only been running right around 12.5% (and that was a few years ago before the drop in stock prices really happened). 9 to 11% is a realistic number.

The idea behind asset allocation isn't to maximize your return in any one year. The goal is to maximize the overall return by smoothing out the ups and downs of the market.

Stocks and bonds tend to run counter to each other. In other words, when stocks do well, bonds generally don't. When bonds do well, stocks usually slide. The idea of asset allocation is to make sure that you participate in both beneficial movements, while not being fully exposed to the drops in each individual market.

But it really isn't enough to allocate your assets just among stocks, bonds and cash. You also need to allocate within each class. For instance, you would want to have some large-cap stocks, some small-cap stocks, and maybe even some international stocks. In bonds you might want to have some government bonds or some high-yield bonds. Each choice that you make will affect the degree of risk and return for your portfolio.

This is where mutual funds come in to play with asset allocation. They allow you to create a well-rounded portfolio without having to put up a small fortune. If your model calls for $5000 in stocks, rather than investing it all in one stock that could do poorly, you can put some in large-cap stocks and some in small-cap stocks, achieving an additional level of diversification in your account.

But how do you know how to allocate your portfolio or how much you should put into each investment class, category and type?

Most brokerage firm websites have some form of an interactive asset allocation modeling program that will give you some broad overviews of things you might want to do. For instance, they will help you to learn your risk tolerance level and will provide some model allocations (like 60% stocks, 30% bonds, 10% cash) that will get you pointed in the right direction.

If you have an account with some firms, they may have another program for customers only which would take the 60,30,10 model and maybe say of the stocks do 50% large-cap, 30% small-cap and 20% international.

Quicken has an asset allocation modeling program built in, also. It is decent and is certainly as good as most of the free ones you will find on the net.

The best option, and the one that may cost some money - especially now that brokers are looking for anyway to turn a dime - is to sit and talk things over with your broker or financial advisor. All of the computerized models are canned standard responses based on a mathematical formula. Your broker can help you to tailor a real model, just for you, taking into account your wants and desires.

Asset allocation is one of the most powerful tools in investing. The smoothing effect that it can have on a portfolio over the long term can be phenomenally beneficial. It can also do wonders for some folk’s mental health, if the gyrations of the market are too much.

If you're serious about long term investing as opposed to trading, research asset allocation. Figure out what allocation will be best for you.

It is the best help you can give yourself in the market.

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part III - Options

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VI - Mutual Funds

Part VIII - Bonds