MONEY TALKS - Asset allocation is the concept of diversifying a portfolio across several asset classes to reduce the portfolio’s exposure to risk. Your asset allocation is critical to the success of your portfolio because it is the driving factor that determines both risk and return. While the specific investment selections you make are important, they are far less crucial than the amount of money you commit to each asset class.
Two-Step Process - Creating a proper portfolio is a two-step process. The first step is selecting an asset allocation that is aligned with your needs. The second step is selecting the specific investments that fit into the asset classes you selected. Identifying your personal and financial needs is an essential step towards selecting your asset allocation. Traditionally a young investor can be more aggressive than an investor in their sixties because they have time on their side to overcome a market downturn. However, that is not always the case. Your health, job security, cash flow needs, and risk tolerance are all important factors that should be considered when selecting an appropriate asset allocation. The point is, your portfolio should be unique to you and your situation. Just because you and your neighbor are the same age doesn’t mean that you should have the same allocation. Likewise, your allocation at 25 will likely be inappropriate for you at 55. Find an asset allocation that works for you and your current situation and update it as your circumstances change.
Specific Investments - Selecting specific investments that fit into an asset class can be a challenge because of the level of detail involved. Asset classes are broad categories of dissimilar investments such as stocks, bonds, real estate, and money market funds. Each asset class can then be divided into specific categories. For example stocks can be divided into U.S. stocks and foreign stocks, while bonds can be divided into taxable or tax-exempt. These specific categories can then be divided again into different styles. U.S. stocks can be divided into small, medium, and large cap. Bonds can be divided into investment-grade or below-investment-grade. This division can go on and on until you have narrowed down a broad asset class into a specific category, style, and sector such as U.S. small cap health care stocks. With thousands of investments to choose from one might ask; how can I possibly select investments that represent all these asset classes, categories, styles, and sectors?
Broad Diversification - Thankfully there are investments out there that allow an individual investor to create a broadly diversified portfolio at a reasonable costs. Index mutual funds and exchange traded funds (ETFs) are an excellent tool to build a portfolio that has an appropriate allocation where the specific investments fit into the appropriate asset class, category and style. The nature of these funds allow an investor exposure across broad market segments without the time, energy, and cost of purchasing individual securities. In fact, most investors can create a fully diversified portfolio by purchasing 5 or 10 of the right index funds or ETFs.
Investment Objective - The question remaining is, how do I select the appropriate funds to create a successful portfolio that is diversified among different asset classes? Start by looking at the investment objective of the fund. For example, a fund designed to track the performance of the Standard & Poor’s 500 Index would be a good fit for the U.S. large cap portion of your portfolio. Next examine the strategy of the fund. Typically passive funds that are designed to match the benchmark index have much lower cost associated with them than do actively managed funds where the manager is trying to beat a particular market. Finally be sure to check the expense ratio which includes management fees, marketing fees, other expenses, and annual operating expenses of the fund. Two funds may be managed identically to one another, yet, one could have significantly higher fees.
Reduce Your Exposure - Regardless of your investment strategy, it’s essential that you reduce your risk exposure by diversifying among different asset classes. Develop a strategy that is aligned with you and your future, and stick to it. Having said that, don’t be afraid to make changes as you mature and your responsibilities change. Review you asset allocation annually and rebalance as necessary, but avoid trying to build the perfect portfolio. Barring any major life changes, most of us should only need to overhaul their asset allocation every 5 or 10 years.