Before money can be invested, the wise investor must believe in this crucial concept: don’t put all of your eggs in one basket. Asset allocation is the art of balancing risk and reward through the diversification of your investments into appropriate asset classes. It’s one instrument that helps to determine the appropriate blend between fixed and equity assets. It helps to smooth out the peaks and valleys that you find in the more volatile portfolio.
There are three ways to pursue investment results: market timing, security selection, and asset allocation.
Market timing is trying to predict what an investment, an asset class, or the market will do before it does it. Timing the market is a difficult strategy. In order to effectively time the market, you’d have to sell before the market goes down and be fully invested during market upswings. Often this means investing money when you are the least comfortable and taking money out when you feel the best about your performance-which is against human nature.
Because the market is highly unpredictable and emotions tend to lead us in the wrong direction, I often recommend against timing the market.
Proper security selection requires a lot of research, monitoring, discipline, and the removal of emotions. As a result, most people prefer to invest in exchange traded funds (ETFs) or mutual funds. ETFs and mutual funds have anywhere from a few to hundreds (or even thousands) of underlying investments with a manager making the decisions on what to buy and sell.
For those who have the time, knowledge, and desire to purchase individual securities, you’d want to first research an investment strategy or theme that you’ll think will work best for you. Strategies you could use include (but are not limited to) value investing, socially responsible investing, creating an income portfolio, investing for growth, growth at a reasonable price (GARP), or a strategy based on technical analysis. You’ll then use that strategy to create metrics for determining which investments fit your criteria and a plan for when you’d buy and sell those investments as part of your portfolio.
Asset allocation is a process of determining the right asset mix for you. As you develop your portfolio, remember that there isn’t a cookie-cutter solution. Just because you’re in your 60’s doesn’t mean that you should have 60% in stocks and 40% in bonds. You have your own goals, risk tolerance, and amount of money to use for those goals. What you need to do is to find the appropriate blend of investments to achieve your desired return within your level of risk and suited to your time frame.
As you’re looking at investments, try to research all available asset classes. Your allocation could include small, medium, or large U.S. companies; small, medium, or large international companies; emerging markets; bonds; or investment real estate. If your portfolio is large enough, then you may look to expand your allocation by investing in sectors of the market or utilizing other asset classes.
In his work on modern portfolio theory, Nobel Prize winning economist Harry Markowitz found that only 1.8% of the average portfolio’s return is attributed to market timing, 5.6% of investment return can be attributed to security selection, and that an appropriate asset allocation accounts for 91.5% of a typical portfolio’s return. While that’s widely known, what isn’t as openly discussed is that a portfolio might be fully diversified with as few as 30 stocks. Of course, those variables can change based on sector concentration, weighting of the holdings, and how much is spread across companies of various sizes and countries.
As you can see, the key is creating a diversified portfolio and investing in that portfolio for the long term. I typically suggest that clients rebalance their portfolio on an annual basis to make sure that one portion of their portfolio hasn’t grown too large. By rebalancing, you’re essentially taking the best performer and selling while it’s high and moving that money to an area that is not performing as well and buying low.
If you’d like to learn more about your tolerance for risk, click here for a free portfolio risk analysis.
This article is for informational purposes only and is not intended to provide specific advice to any individual. Consult your legal, tax, and/or financial advisor to determine what is appropriate for your situation.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Diversification and asset allocation do not protect against market risk.
Stock investing involves risk including loss of principal.
Away from the Office
July 4th & 5th
Our office and the markets will be closed on July 4th for Independence Day. Our office will also be closed on July 5th. Have a great holiday!
Woody will be out of the office for jury duty.
Woody will be out of the office.
We are always accepting donations for the local animal shelters– toys, tennis balls, collars, leashes, food, cat litter, cardboard trays, office supplies, cleaning supplies, towels, mats, washcloths, etc. We will accept donations Monday-Friday between 9am & 5pm.
Elise had her 5th birthday this month. Because we treat birthdays like national holidays, the family took the day off to celebrate. After loading up on cake and opening gifts, we spent the afternoon at one of Elise’s favorite places, the pool. It was a wonderful day that was capped off by her asking me at bedtime, “Daddy, am I really 5?”
We spent Father’s Day at the same beach my parents and grandparents took me to as a child. This was Elise’s first visit to Wildwood. Watching her enjoy all the rides I went on at Elise’s age was better than any gift she could have bought me.
I hope you enjoyed this month’s newsletter.
Woody Derricks, CFP®, ADPA®