Asset allocation is the percentage of assets allocated to each asset category within an investment portfolio. Think of it as a percentage invested in equity/bond/cash/real estate/alternative investments.
There is no perfect asset allocation, a one size fits all solution does not apply. An asset allocation is subjective, unique to individuals and derived from investment goals/time horizon and risk tolerance.
How does an investor decide which allocation is right for them? To start, you must understand that an asset allocation begins with a portfolio. You might have one portfolio for a house down payment and another for retirement. Each ought to have its own distinctive portfolio because comingling funds typically breaks down rather quickly – the line between them is no longer distinct making asset management difficult.
Once you identify distinct portfolios, consider time as a contributing factor – determining how soon you need the money directly affects your decision. If you need it tomorrow, all cash is probably a good idea. If you need it at retirement and retirement happens to be years away, a good mix of stocks, bonds and cash is acceptable.
Another factor that follows your portfolio time horizon is risk. Knowing yourself and whether you panic and sell at the slightest market drop helps determine your allocation. You may want to be in ‘less-risky’ asset classes if you have a tendency to panic. However, as economics teaches us, this comes with an opportunity cost and that cost sacrifices portfolio growth for safety.
Since risk is a mindset, turn your thinking around and see it as an opportunity. Rather than viewing a 20% market drop from a panic-stricken state and selling everything, simply view it as an opportunity to buy more using assets that either increased and/or remained unchanged by employing portfolio rebalancing. Rebalancing restores your portfolios to their origninal asset allocation and it creates wealth.
One of the most difficult things for novice investors is deciding where to begin. A recent college graduate with limited funds might start with a short term bond fund. As savings build, add a large cap domestic equity fund followed by adding a domestic intermediate term bond fund. More adept savers have the choice of redistributing their assets all at once or over a period of months, whichever is more appropriate for them.
Having the discipline to monitor your portfolios is a cumbersome task and we all seek ease-of-use. That is where Track My Portfolios helps – the foremost authority on portfolio tracking and they make your investing life easy by monitoring your portfolios and alerting you when rebalancing opportunities present themselves. Visit them at Track My Portfolios for details.
Establishing the purpose behind a portfolio is your starting point. Your asset selection comes from knowing your risk and time horizon. Risk adverse or a short time horizon lends itself towards short term instruments, whereas less risk adverse investors or a longer time horizon would lean towards longer term investments.
Therefore, understanding asset allocation and having the knowledge of how to apply it to your various portfolios is very important when it comes to investment success. Combined with rebalancing at the appropriate time, you will achieve your investment objectives.
Follow these steps to fully implement an intelligent asset allocation strategy:
- Create Purposeful Investment Portfolios
- Each portfolio maps to a specific end-goal
- Know Your Investment Time Horizon
- Short term portfolio examples
- Car down payment
- House down payment
- These lean towards bonds and cash, less equities
- Long term portfolio examples
- A young child’s college education
- Retirement
- These lean towards equities
- They may eventually gravitate towards bonds and cash depending upon the withdrawal period
- Understand Your Risk Tolerance
- Determine your investment temperament
- Will you transact on emotions or logic?
- Determine Your Asset Allocation Percentages
- Implement Your Asset Allocation Strategy
- Invest all at once
- Alternatively, over the course of time
- Either way is okay, there is no 'absolute' formula
Good luck and may you achieve your life goals.
G. Michael Kennedy
Financial Strategist
Family Financials, Inc.