Asset Allocation: Part 1 of 5
By Colleen Mulder-Seward, MBA
Often financial “experts” make
asset allocation difficult to understand. My goal in this
series of articles is for you to understand asset allocation
thoroughly, in an easy to understand format. Through this
series of articles, you will learn (1) what asset allocation
is and why it is important, (2) what determines your asset
allocation, (3) the main asset categories, (4) your ideal
asset mix, and (5) when and how you should rebalance your
portfolio. This first article will teach you what asset allocation
is and why you need to use it.
Asset allocation simply means how your investment
portfolio is divided across different asset classes or investment
types. This is often confused with diversification. Diversification
refers to buying a number of investments within an asset category
to reduce investment risk.
Asset allocation theory states that by dividing
your portfolio into different types of investments, you can
reduce the volatility of your portfolio. Some financial experts
claim this is more important than the individual stocks you
choose. I believe that both proper allocation of your portfolio
and careful selection of investments within each asset category
is the key to long-term investment success.
There are two main types of asset allocation
– strategic and tactical. Strategic asset allocation
is a long-term approach to how the assets are to be divided
among various investment categories. Using strategic asset
allocation, your asset mix only changes if your life circumstances
change. Thus, it is a less active approach to asset allocation.
Tactical asset allocation is active portfolio management that
attempts to improve investment performance by shifting money
from one investment category to another. Since tactical asset
allocation is a more time-intensive practice and can result
in a higher level of risk verses reward, when compared to
strategic asset allocation, this series of articles will focus
exclusively on strategic asset allocation.
Asset allocation of yesteryear used to be simple.
The formula was to subtract your age from 100. This resulted
in the percentage of your portfolio you should have invested
in stocks. For example: a 65-year-old would have 35% in stocks
and 65% in bonds and cash. But, due to longer life expectancies,
people run the risk that their investments will not grow fast
enough to last their lifetime, when following this formula.
Reading this series of articles and using the retirement calculator
available at www.retirementcalc.com can help prevent this
from happening to you.
In our next newsletter, you will learn
what determines your asset allocation.