Asset allocation is a common strategy that you can use to construct an investment portfolio. It isn’t about picking individual securities but focusing on broad categories of investments and mixing them together in the right proportion to match your financial goals, the amount of time you have to invest and your tolerance for risk.
The idea behind asset allocation is that because not all investments are alike, you can balance risk and return in your portfolio by spreading your investment dollars among different types of assets, such as stocks, bonds, real estate, cash and other alternatives. It doesn’t guarantee a profit or ensure against a loss, but it can help you manage the level and type of risk you face.
Different types of assets carry different levels of risk and potential for return, and typically don’t respond to market forces in the same way at the same time. For instance, when the return of one asset type is declining, the return of another may be growing (though there are no guarantees). If you diversify, a downturn in a single holding won’t necessarily spell disaster for your entire portfolio.
When using asset allocation, you identify the asset classes that are appropriate for you and decide the percentage of your investment dollars that should be allocated to each class (for example, 60 percent to stocks, 30 percent to bonds and 10 percent to alternatives). Your objective in using asset allocation is to construct a portfolio that can provide you with return on your investment without exposing you to too much risk. Your investment time horizon also will affect your allocation mix. The longer you have to invest, the more time you have to ride out market ups and downs.
When you’re trying to construct a portfolio, you can use worksheets or interactive tools that help identify your investment objectives, your risk tolerance level and your investment time horizon. These tools may also suggest model or sample allocations that strike a balance between risk and return, based on the information you provide.
Once you’ve chosen your initial allocation, revisit your portfolio at least twice a year (or more often if markets are experiencing greater short-term fluctuations). One reason to do this is to rebalance your portfolio given market fluctuations. For instance, if the stock market has been performing well, eventually you’ll end up with a higher percentage of your investment dollars in stocks than you initially intended. To rebalance, you may want to shift funds from one asset class to another.
An investor should select an allocation and implement it versus waiting for the perfect time or jumping in and out of the market. Investors who attempt to time the market run the risk of missing periods of exceptional returns which may lead to significant, adverse effects on the ending value of a portfolio. In the 20-year period ending December 31, the S&P 500 stock market averaged 8.2 percent annually. However, missing the best 10 days would reduce that return to 4.5 percent annually and missing the best 50 days would further reduce it to 3.7 percent annually. Of course, an argument can be made that missing the worst 10 or 50 days will significantly increase the annual returns but do you really think you can do that? You have a much higher risk of failure in not being invested than choosing an allocation strategy to reach your goals while balancing your acceptable risk.
If you’re no longer comfortable with the same level of risk, your financial goals have changed or you’re getting close to the time when you’ll need the money, you may need to change your asset mix. While many investors think they can take the emotion out of investing, working with an experienced professional can alleviate this risk much better than managing it alone.
Life is a journey, plan for it.
Neil A. Brown is a CPA and CFP with Burkett Financial Services in West Columbia. Reach him at www.uscneil.com or (803) 200-2272.