We talk and write a lot about how important it is to have a plan for managing your long-term investments, particularly your retirement accounts. Regular listeners to Smart Money Management know how important we consider asset allocation to be as a basic tenet of your overall investment plan. When the markets become volatile, as they have in the last two months, asset allocation can be an important tool.
Asset allocation is simply how you spread your investments among the different asset classes. The three main asset classes are cash, bonds and stocks. The correct asset allocation is different for every investor, depending on his or her individual circumstances. Each asset class has unique properties that are an important part of your overall portfolio. Cash includes things like savings and checking accounts, money market accounts, short-term certificates of deposit, and other fixed-income investments with a maturity of six months or less. Cash investments are very liquid and are characterized by very little, if any, fluctuation in value. Bonds are fixed income investments with a maturity of greater than six months. There are many types of bonds - treasuries, municipal, and corporate are some of the most common. The value of bonds will fluctuate based on movements in interest rates. Bonds generally provide a steady, predictable cash flow, but not much potential for capital appreciation. Both cash and bonds provide little protection against inflation. Stocks represent ownership in a company, and owners of shares of stock benefit from the companies profit as well as future growth. Stocks offer the potential for capital appreciation, but less predictable cash flows. Stocks are also the most volatile of the three asset classes. (Source: Markowitz, Journal of Finance) Stocks are further classified by size, style and geography. Size is self-explanatory: Large companies, medium-sized companies and small companies. Style refers to value or growth. Value stocks are generally more mature companies that are attractive because of their valuation relative to their cash flow and other characteristics and their valuation relative to similar companies. Growth stocks are often newer companies in the early part of their lifecycle, with rapidly increasing sales and market share. Geography refers to where the company is located, either in the US or outside of the US.
The correct asset allocation for each investor is different, depending on age, goals, financial situation, risk tolerance, and time horizon. An investor may have multiple portfolios each with different asset allocations. For example, let’s say an investor is pursuing three goals: buying a new boat in one year, buying a new house in five years, and retiring in 30 years. The account earmarked for the boat will probably be invested almost exclusively in cash, because the use of the proceeds will be in the very short-term. The account intended for the new house may contain a mix of bonds and cash, while the retirement account will likely include all three asset classes, with a large portion invested in stocks.
Diversification and asset allocation are related concepts, but they are not the same thing. Diversification can be thought of as not putting all your eggs in one basket. For example, an investor could have a portfolio made up of 20 stocks. That is a diversified stock portfolio, but it may not be the correct asset allocation because it is made up entirely of stocks. By adding additional asset classes to a portfolio, you may be able to increase returns with the same amount of risk or decrease risk while maintaining returns. (Source: Markowitz, Journal of Finance)
Asset allocation is part of your overall financial plan, and like all aspects of your plan, should be reviewed periodically. The asset classes will have different returns each year, and over time your portfolio can become out of balance. Part of your review process should be to rebalance back to the correct allocation for each asset class. Your overall asset allocation plan will also change over time as you get older, the time horizon for your goals shortens, and your financial circumstances change. Short-term market conditions may not be a good reason to change your asset allocation plan, however. In fact, adding discipline to your portfolio may be an additional benefit of having an asset allocation plan.
To hear the podcast of the Smart Money Management radio show on this topic, or others, go to our website at alderferbergen.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Asset allocation does not ensure a profit of protect against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
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