Managing Your Investment Portfolio: Part Six
Asset Allocation
by Gerald Townsend, Financial Editor
June 2010
We are now at the half-way point in this series of articles on managing “Managing Your Investment Portfolio.” So far, we’ve discussed goal-setting; determining risk tolerance and capacity; examined the impact of time, taxes and economic considerations on portfolio planning; and how to develop a blueprint for managing your portfolio.
This month, we turn our attention to asset allocation, which immediately raises a question: Exactly what is “asset allocation?”
Asset allocation is the process of allocating your investments across several “asset classes.” The most common asset classes include cash (money market funds, CDs, etc.); bonds or other fixed-income assets; and stocks. This could be done by investing in individual securities or by using mutual funds.
An “asset class” is simply a way of grouping investments that have similar risk and reward characteristics. You could also drill down into sub-classes. For example, stocks could be further allocated among the stocks of large companies, smaller companies, or foreign companies. Alternatively, a sub-class could be created based on investment approaches or styles, such as “value” (stocks with cheap valuation ratios) or “growth” (stocks with high sales or growth ratios).
Other asset classes used by investors include real estate, commodities, currencies, tangibles, and private equity. While it is sometimes difficult to know if a certain type of investment actually constitutes an asset class, the important thing to remember is that all the investments in an asset class should generally move up or down with the other investments in that class.
Asset allocation is not the same thing as diversification. If your portfolio consists of 100 different stocks, you are probably well-diversified, but you still have all your investments in just one asset class. By allocating some of your money away from stocks and towards cash and bonds, you are balancing out the risk and reward.
Keep in mind that your asset allocation should not necessarily be the same as someone else, because of differences in goals, risk tolerance, age, income, budget needs, and personal preferences.
There are many methods and approaches utilized to create an asset allocation. They range from relatively simple to highly complex. For example, a simple approach is to subtract yoThe process of asset allocation will not prevent your portfolio from suffering when a significant market event occurs, such as the recent recession. It is not a panacea or cure-all for all the risk of investing. However, it will help you to balance the risk and reward of investing and lessen the likelihood and impact of a major loss in your portfolio.ur age from 100 and use the result to determine the amount invested in stocks. Therefore, a person age 60 would have 40% of their portfolio in the stock market. This obviously ignores other criteria, but it does recognize the common sense rationale of gradually reducing the exposure to riskier assets, such as stocks, as a person ages. Unfortunately, it fails to discern the difference between more conservative vs. more aggressive stocks and also does not address the inherent risks in other asset classes, such as bonds.
Let’s assume for a moment that your current asset allocation is 20% in cash, 30% in bonds, and 50% in stocks. What will cause you to make a change from this allocation?
First of all, a change might happen because of something personal. You may get a new job or you might retire. Your expenses might rise or fall. A key life goal might change. Finally, your tolerance and financial capacity for risk is an ever-changing variable, and this might cause you to rethink your asset allocation.
Next, you might consider changing your asset allocation simply due to what is happening in the marketplace. Stock prices might fall, causing you to perceive a buying opportunity, and resulting in you increasing your stock allocation to some degree. On the other hand, the yields on cash or bond investments could rise and you might shift some of your money from stocks to those asset classes.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com