Last post, we talked about risk tolerance and its role in investment strategy. The next step in investing for your financial goals is understanding the importance of asset allocation. In its simplest terms, asset allocation is the diversification of an investment across the main asset classes of cash, equity and fixed income. There is even an often quoted study from 1986 that states that 94% of the variation in investment returns is determined by the chosen asset allocation. Granted, that study was conducted almost 25 years ago, but asset allocation still has a big impact today on your potential investment returns.
Asset classes, which can be divided further into subsectors called asset categories, have varying levels of risk and return. Equity and Fixed Income will behave differently depending upon market conditions and may even perform in direct opposition to one another. Therefore, chasing asset class or category performance isn’t effective over the long run. If you are only investing in the best performing asset category from last year or last quarter, you may find you are always one step behind the market. See last year’s Callan Chart of Investment Returns, described as a “comprehensive representation of relative asset class performance over the last 20 years.” Notice how some of the worst performer s in one year will be the best in another and vice versa.
Asset allocation allows an investor to develop an investment strategy that instead of blindly following returns, takes into consideration both an investor’s risk tolerance and investment objectives. So, how do you determine your asset allocation? There are a number of tools out on the internet to do just that. Some are very advanced and costly; others are fairly simple and free.
Free internet asset allocation calculators like this one are easy to navigate and use sliding ranges for data entry, but assume you already know your risk tolerance. Others, like this one, have more limited, multiple choice entries, but ask questions to help you determine your comfort with risk. If you want something more personal, don’t forget to check with your financial advisor, as they probably have an asset allocation tool they use on a regular basis which they can explain to you in more detail.
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Elizabeth,
Balancing and re-balancing a portfolio is far more work than most people want to do although it is necessary in order to maintain a peak return. This is an area where an advisor can be very helpful. What are your thoughts regarding the various funds which attempt to maintain an asset balance appropriate for someone in their early, middle, late employment years or retirement years?
Don
Comment by donmack — May 29, 2010 @ 12:10 am
Donmack, you’re always right on topic, and in this case, one step ahead of me.
This week, I’ll be adding to the risk/allocation conversation with the last piece, rebalancing. While target and allocation funds can be very useful, individuals who invest in them should understand just what they are targeting and how the allocation does or does not change. Stay tuned.
Elizabeth
Comment by NEAMB Elizabeth — June 2, 2010 @ 12:37 am