When asked by a waitress whether he would like his pizza cut into six or eight slices, Yogi Berra is reputed to have said, "Six. I'm not hungry enough to eat eight slices of pizza." How you slice the pie is the key to successful investing, too.
Many investors spend the lion's share of their time and energy on deciding which stock or bond to hold in their portfolios. Asset allocation, however, can be much more important. Asset allocation is the process of spreading your investment dollars into more than one type of investment. The idea is to choose investments that are not similarly affected by the same business, economic or world events.
Asset Allocation Means Diversification
In the 1950s, Nobel Laureate Harry Markowitz revolutionized the financial markets by showing that owning a diversified portfolio of stocks could lead to higher returns with less risk than owning any individual stock. He discovered that, while you can add the returns on the individual securities in a portfolio to get the portfolio's overall return, you cannot add up the risks in the same way. By choosing investments that react in different ways to market and economic events, you can lower the overall risk of your portfolio without giving up return.
Asset allocation is the process of deciding how much to invest in different asset classes, such as large-cap stock funds or government bond funds. This is different from security selection, deciding which particular stock and bond funds to hold. For most individual investors, the asset allocation decision centers on what types of mutual funds to invest in, and the amount to invest in each type of fund.
Asset Allocation Determines Performance
The choice of which asset classes to invest in is the single most important determinant of investment returns. An ongoing study of pension funds? investment earnings conducted by Chicago-based Brinson Partners and published in the Financial Analyst's Journal, indicated that the asset allocation decision accounts for 94% of the variability in a portfolio's total return.
The selection of individual securities within each asset class accounted for 4% total return. The ability to strategically reallocate among asset classes in response to anticipated changes in the market contributed to the remaining 2% of total return.
Finding the right mix
What's the right asset mix for you? That depends on two considerations: your personal investment goals and your comfort level with the typical fluctuations of the stock market. You need to consider both factors in your asset allocation plan.
Determining your investment goals doesn't have to be a formal exercise. Just write them out on a piece of paper and divide them into three categories:
- Short-term goals: less than two years away
- Intermediate-term goals: those three to six years away
- Long-term goals: those seven years or more away
For many people, the most important long-term goal is retirement, followed by saving for a child's college education. However, your own definition of short- or long-term goals will depend on your life stage. If you're 30, retirement is a long-term goal. If you're 60, it may be a short-term goal.
Determine Your Investment Personality
Your goals are only one part of the asset allocation equation. A second important component is personality. Some investors are perfectly comfortable with big swings in the financial markets and view any drop in prices as an opportunity to pick up investments at bargain prices. However, if you are the kind of investor who cannot tolerate fluctuations, you should recognize your reluctance and plan your investment strategy accordingly.
There are steps you can take to deal with your fears. Learning more about what makes the stock market go up and down can help. And working with a trusted investment consultant who can explain financial markets is an even better way to expand your investment comfort zone.
Reaching Your Goals
According to a recent Federal Reserve estimate, most investors are decidedly cautious when it comes to asset allocation. Their figures reveal that, on average, investors have less than 20% of their financial assets in stocks and stock mutual funds, which have provided the highest long-term returns.
While a conservative investment approach may limit risk in the short-term, it could keep you from reaching your long-term investment goals. That is what asset allocation is all about. It cannot guarantee that you will reach all of your financial goals, but it can be a powerful tool in your quest to become a more successful investor.
The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Asset allocation/investment timing cannot eliminate the risk of fluctuating prices and uncertain returns. Securities offered by Howe Barnes Investments, Inc., member NASD and SIPC.