Investing Secret Four, Know the Merits and Limits of Asset Allocation
Diversification is a strategy that can be summed up by the adage "Don't put
all your eggs in one basket." This part of your plan involves spreading your money among various investments with the expectation that if one investment loses money, the other investments will balance out your risks and make up for those losses. It includes setting a goal or expectation of achieving a certain rate of return across all of your investments over time.
All investments contain a degree of risk. Asset allocation helps to manage those risks by striking a balance between different types of investments (often referred to as "asset classes").
Asset allocation involves dividing an investment portfolio among different assets such as stocks, bonds, and cash. This can be done with a small amount of money simply by investing in a mutual fund. As your asset grow, you need to buy additional assets in other categories. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk. Over time these will change, and you should therefore adjust your allocations. Just buying assets in a 401K or IRA account and forgetting them until retirement is the biggest mistake the causal investor can make. A successful investor needs to actively manage there accounts by at least rebalancing the assets to meet your expectations at least 2-4 times a year.
The key decision for anyone looking to use asset allocation is which assets to hold. Think of this way. It's Thanksgiving and you your plate can only hold a few slices of pie, but you like some each: pumpkin, apple, cherry, pecan, and banana cream pies. By taking a slice of each you get to enjoy (at least for one day of the year) all the pleasures of yummy desserts. Asset allocation is a bit like that. Except it is a bit more disciplined.
Merits of Asset Allocation
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride.
The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Limits to Asset Allocation
The decision of how to diversify your investments across various asset choices is a difficult one, made only more complicated by the every expanding number of choices. The apparent simplicity of asset allocation has a powerfully appeal to many investors. A portfolio composed of stocks, bonds and t-bills is now regarded as inadequate. To be 'properly' diversified poplar advice is you need more a elaborate portfolio, including:
Large and small cap domestic stock funds
US stock funds
European stock funds
Pacific Rim stock funds
Latin American or emerging markets funds
Domestic bond funds
Global bond funds
High yield bond funds
Real estate funds
Commodity futures funds
To the average investor however this multiplication of asset classes is impractical, and makes investing for the average guy confusing. Keep it simple, if you have less than 10,000 to invest, only invest in a solid US stock fund, a global fund and bond fund that covers the bond market. As you have more money available you can add more asset classes, but avoid the temptation of buying a little of everything and calling it asset allocation.
How to Get Started
Determining the right asset allocation is a complicated task. Basically, you're trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. As you get closer to meeting your goal, you'll need to be able to adjust the mix of assets.
Try to do a few simple calculations of market returns:
current yield for cash equivalents,
yield to maturity for bonds
dividend discount model rate of return for equities.
This can give you some guidance for asset allocation by comparing the market outlook for various asset classes. Transforming this information into an asset deployment strategy is, of course, the critical step. If it is handled in an casual fashion, the temptation will be to ignore the opportunities at precisely the wrong time.
Investing Secret Four, Know the Merits and Limits of Asset Allocation
By: Floyd Saunders
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