Asset Allocation Basics

March 12th, 2008 at 07:18am Tom Ptacin

   Thomas J. Ptacin, MBA, CFP® 

The term Asset Allocation is not new to the field of personal finance. Prudent investors seeking to diversify the risk in their portfolio divide investment dollars into a broad array of asset classes. While the concept is simple, the construction and implementation of a properly diversified portfolio is not. Below I will discuss some issues that need to be considered when allocating your investment assets.

In previous blogs last week, Amy Barrett shared some ideas for determining investor risk tolerance and a proper ratio of equities to fixed income. Generally speaking, those with a long time horizon until retirement can and should consider to be heavier in equities. As the investor ages and gets closer to retirement years, the need for preservation and stability emerges and increasing the allocation to fixed income typically makes sense. However, don’t overdo it. People are living longer and many retirements last in excess of 30 years. The risk of your portfolio eroding from inflation needs to be mitigated by maintaining some degree of exposure to equities in your portfolio.

Once you’ve chosen a mix of equities and fixed income that you are comfortable with, the next step is to determine the breakdown of the equity and fixed income components. When determining your asset allocation mix you should consider the following:

Invest in our Friends Overseas: By concentrating solely in the United States, you are ignoring over half of the global stock market capitalization. A mixture of domestic and international equities provides greater opportunities for diversification.

Don’t Forget about the Little Guys: Small Cap stocks actually have a higher expected return than Large Cap stocks. Furthermore, small companies have a low correlation to their big brothers. This means that oftentimes when Large Cap stocks are struggling, the small cap stocks are performing well. Healthy allocations to small cap stocks offer a great complement to the large caps in your portfolio, both in the US and Internationally.

Include the Tortoise along with the Hare: Growth stocks (the hare) can be exciting, but surprisingly value stocks (the tortoise) have historically come out ahead more often. Having a combination of growth and value stocks is important. Either is capable of winning the race in any given year. Unfortunately it is impossible to know the winner ahead of time.

Short isn’t so Bad: Try to limit the maturities on your bond portfolio to short and intermediate lengths. While long-term bonds typically offer slightly higher yields, they also come with more risk. Reducing portfolio risk on the bond side can allow you to spend more risk on the equities, which have a higher expected return.

Entry Filed under: Asset Allocation