Asset Allocation and Diversification
Asset allocation refers to how much money you have invested in each of the major asset classes such as stocks, bonds and cash. Studies have shown that asset allocation is one of the most important investment decisions an investor can make, accounting for as much as 90% of return. Asset allocation is the process of determining the percentage of your investment portfolio that each asset class should occupy, based on your risk tolerance. Each asset class provides you with a different level of risk and different levels of potential return. Owning just one asset class, such as stocks, would be risky because the value of your entire portfolio would depend entirely on the performance of that asset class. The overall purpose of asset allocation is to reduce volatility so that thriving investments in one asset class potentially outweigh losing investments in other asset classes. To determine your asset allocation you first need to determine your risk tolerance. Two important factors that affect your risk tolerance are your time horizon and your personal response to risk. Your time horizon is the amount of time you have before you will need the money you are investing. In general, if you have a long time horizon (10+ years) you can invest with a higher risk tolerance (aggressive). A moderate time horizon (5 – 10 years) can tolerate moderate risk and short time horizons (1 – 5 years) should use a low (conservative) risk tolerance. However, the second factor, your personal response to risk, must also be taken under consideration. If you avoid risk in everyday life or worry easily, you need to be more conservative. You don’t want to get ulcers or lay awake at night worrying about your aggressive investments even if you have a long time horizon. If you enjoy risk and don’t worry easily, then you may want to lean toward the aggressive allocation, if you time horizon allows it. A very basic model for asset allocation is as follows: Stocks Bonds Cash Equivalents Conservative 10% 20% 70% Moderate 50% 20% 30% Aggressive 75% 15% 10% There are many, many asset allocation models out there but they all follow the basic premise of having a higher percentage in stocks (or stock mutual funds) as you move from conservative to aggressive with the bonds/cash moving in the opposite direction. Don’t overestimate your tolerance for risk in good times. If you are invested too aggressively when the market is rising, you are more likely to abandon your investment program when the market is falling. The most ideal asset allocation is that mix of assets that you can stick with in good times and in bad. You also need to diversify within the major asset classes. As an extreme example, a portfolio with one stock, one bond and cash could have proper asset allocation but is not diversified at all. Most investors should invest no more than 5% in an individual stock or bond. Diversification refers to owning various investments within each asset class. Don’t own all or your stocks or mutual funds in one industry (such as technology). Don’t own all municipal bonds or municipal bond funds. Stocks and stock funds (also called equities or equity funds) are divided by their market capitalization, their investment style, sector and geographic location. Market capitalization (market cap) is equal to the number of shares the company has issued to the public multiplied by the value of a single share. So the terms large cap, mid cap and small cap basically refer to large companies, mid size companies and small companies. Investment style refers to whether a mutual fund invests in growth stocks or value stocks or a “blend” of both. Growth funds invest in companies that are rapidly growing businesses. Value funds invest in companies of established, slower-growing businesses. Those funds that invest in a mix of growth and value stocks are called blend funds. Sector refers to the specific industry a company is in or a fund invests in. Examples are energy, financial services, utilities, health care, technology. Geographic location refers to investing in companies from a certain part of the world. Many funds are just focused on the US while others may focus on only foreign stocks or just stocks from a particular region such as Latin America, Asia, China, etc. If we put these different types of assets on a risk continuum it would look as follows: Highest Risk Commodities Small cap stock Foreign stocks High yield bonds Mid cap stocks Large cap stocks Real Estate Investment Trusts (REIT) Intermediate term bonds Short term bonds Lower Risk So now if you put everything together that we have learned about asset allocation and diversification we can come up with a portfolio that has both asset allocation and diversification for the greatest potential growth while limiting risk to a level that suits your financial situation and personality. Conservative Moderate Aggressive Large cap stock 10% 40% 35% Mid cap stock 15% 10% 17% Small cap stock 7% 3% 17% Foreign stocks 14% 25% 22% Bonds 43% 22% 9% Real estate 5% Cash 3% Other 3% Again, there are many, many asset allocation models out there and this is just an example of how it works. As before, the percent in stocks grows as you move from conservative to aggressive and the percent in bonds moves in the opposite direction. Below is an example of how you could have asset allocation and diversification with just seven funds. Early to Mid Career Late Career In retirement Blue Chip US Stock Fund FSMKX Fidelity Spartan 500 Index 40% 30% 20% Blue Chip Foreign Stock Fund VGTSX Vanguard Total International Stock 30% 25% 15% Small Company Fund PRNHX T. Rowe Price New Horizons 5% 2.5% 2.5% Value Fund VIVAX Vanguard Value Index 5% 2.5% 2.5% High Quality Bond Fund VBMFX Vanguard Total Bond Market Index 10% 20% 30% Inflation-Protected Bond Fund VIPSX Vanguard Inflation Protected Securities 5% 10% 10% Money-Market Fund FDRXX Fidelity Cash Reserves 5% 10% 20% Morningstar.com is an excellent resource to use for studying your portfolio. Morningstar developed the equity style box where they put the diversification info in a square box for a graphical representation of where the market cap and investing style falls. Value Blend Growth Large Mid Small If you aren’t interested in trying to figure out which funds to purchase and aren’t interested in rebalancing your portfolio once a year, you may be better off putting all of your investments into a target-date fund. These funds invest based on the time horizon you have and re-adjust as you get older and you get closer to retirement. The funds have a year in their name, such as 2025, 2030, 2035, etc. Pick the fund with the year closest to the year you plan to retire. You do have control over the quality of the investments you own, the diversification of your portfolio and how long you hold your investments. Right now, many investors are discouraged, some are angry or upset, and others are just plain confused. The best way to survive any crisis is to have a well-thought-out strategy and not let emotions drive your investment decisions. Time is your greatest friend. Emotions are your greatest enemy. Focus on the things you can control. Base your investment decisions on investment principles, not predictions. The three most important investment principles are focusing on quality investments, diversifying your portfolio and holding your investments for the long term. Don’t abandon those principles. For more information on personal finance and investing visit my blog at http://www.debtandmoneyinfo.com/blog. |
Personal Finance and Wellness