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With literally thousands of stocks, bonds and mutual funds to choose from,
picking the right investments can confuse even the most seasoned investor.
However, starting to build a portfolio with stock picking might be the wrong
approach. Instead, you should start by deciding what mix of stocks, bonds and
mutual funds you want to hold - this is referred to as your asset allocation.
What Is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk
and create diversification by dividing assets among major categories such as cash,
bonds, stocks, real estate and derivatives. Each asset class has different
levels of return and risk, so each will behave differently over time. For
instance, while one asset category increases in value, another may be
decreasing or not increasing as much. Some critics see this balance as a
settlement for mediocrity, but for most investors it's the best protection
against major loss should things ever go amiss in one investment class or
sub-class.
The consensus among most financial professionals is that asset allocation is
one of the most important decisions that investors make. In other words, your
selection of stocks or bonds is secondary to the way you allocate your assets
to high and low-risk stocks, to short and long-term bonds, and to cash on the
sidelines.
We must emphasize that there is no simple formula that can find the right asset
allocation for every individual - if there were, we certainly wouldn't be able
to explain it in one article. We can, however, outline five points that we feel
are important when thinking about asset allocation:
Risk vs. Return
The risk-return tradeoff is at the core of what asset allocation is all
about. It's easy for everyone to say that they want the highest possible
return, but simply choosing the assets with the highest "potential"
(stocks and derivatives) isn't the answer. The crashes of 1929, 1981, 1987,
and the more recent declines of 2000-2002 are all examples of times when
investing in only stocks with the highest potential return was not the most prudent
plan of action. It's time to face the truth: every year your returns are
going to be beaten by another investor, mutual fund, pension plan, etc. What
separates greedy and return-hungry investors from successful ones is the
ability to weigh the difference between risk and return. Yes, investors with
a higher risk tolerance should allocate more money into stocks. But if you
can't keep invested through the short-term fluctuations of a bear market, you
should cut your exposure to equities.
Don't Rely Solely on Financial Software or Planner Sheets
Financial planning software and survey sheets designed by financial advisors
or investment firms can be beneficial, but never rely solely on software or
some pre-determined plan. For example, one rule of thumb that many advisors
use to determine the proportion a person should allocate to stocks is to
subtract the person's age from 100. In other words, if you're 35, you should
put 65% of your money into stock and the remaining 35% into bonds, real
estate and cash.
But standard worksheets sometimes don't take into account other important
information such as whether or not you are a parent, retiree or spouse. Other
times, these worksheets are based on a set of simple questions that don't
capture your financial goals. Remember, financial institutions love to peg
you into a standard plan not because it's best for you, but because it's easy
for them. Rules of thumb and planner sheets can give people a rough
guideline, but don't get boxed into what they tell you.
Determine Your Long and Short-Term Goals
We all have our goals. Whether you aspire to own a yacht or vacation home, to
pay for your child's education, or simply to save up for a new car, you
should consider it in your asset allocation plan. All of these goals need to
be considered when determining the right mix.
For example, if you're planning to own a retirement condo on the beach in 20
years, you need not worry about short-term fluctuations in the stock market.
But if you have a child who will be entering college in five to six years,
you may need to tilt your asset allocation to safer fixed-income investments.
Time Is Your Best Friend
The U.S. Department of Labor has said that for every 10 years you delay
saving for retirement (or some other long-term goal), you will have to save
three times as much each month to catch up. Having time not only allows you
to take advantage of compounding and the time value of money, it also
means you can put more of your portfolio into higher risk/return investments,
namely stocks. A bad couple of years in the stock market will likely show up
as nothing more than an insignificant blip 30 years from now.
Just Do It!
Once you've determined the right mix of stocks, bonds and other investments,
it's time to implement it. The first step is to find out how your current
portfolio breaks down. It's fairly straightforward to see the percentage of
assets in stocks vs. bonds, but don't forget to categorize what type of
stocks you own (small, mid, or large cap). You should also categorize your
bonds according to their maturity (short, mid, long-term). Mutual funds can
be more problematic. Fund names don't always tell the entire story. You have
to dig deeper in the prospectus to figure out where fund assets are invested.
There is no one standardized solution for allocating your assets. Individual
investors require individual solutions. Furthermore, if a long-term horizon is
something you don't have, don't worry. It's never too late to get started. It's
also never too late to give your existing portfolio a face-lift: asset
allocation is not a one-time event, it's a life-long
process of progression and fine-tuning.
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