In the many years involved with investing and in my role as an investment advisor, I often get asked the question of what makes for a successful investment strategy. While no strategy is full proof, one sure way to spread your risk and maximize your reward is through proper asset allocation.
Asset allocation is the process of deciding what percentage of your money to put into the major asset classes: stocks, bonds, cash and precious metals. The three main classes can be further broken down into terms of market capitalization (small-cap, mid-cap, and large-cap), style (such as value or growth investing), and international or domestic securities.
Because each type of asset responds differently to shifts in the economy and financial markets, some investments may be up while others may be down. With asset allocation, a portfolio may experience less fluctuation in value than individual assets within the same portfolio.
In today's markets, investing with discipline involves selecting investments that are in line with an overall asset allocation and diversification strategy based upon your needs, goals, time frames and your ability to assume risk. To meet goals, investors must carefully identify their financial objectives and an investment mix to help them reach those goals.
Of course, when it comes to investing, greater reward generally carries greater risk. So if you're looking for a smart way to reduce investment volatility while still retaining profit potential, then consider the advantages of asset allocation.
This investment technique may have a significant impact on the ultimate success of your portfolio. In fact, asset allocation has more influence on portfolio variance than any other single investment decision. In an important study published by the research team of Brinson, Singer, and Beebower in 1991*, asset allocation was shown to account for as much as 91.5 of the variation in total return, far outweighing other significant factors such as market timing and security selection.
The goals of asset allocation remain the same. For example, asset allocation may help you:
Â· Maximize portfolio return at a reasonable level of risk.
Â· Create a prudent diversification of investment assets.
Â· Meet stated financial goals such as education or retirement funding, and other objectives such
as the purchase of a home.
Â· Accommodate your risk tolerance, investment time horizon and tax situation.
Even though investors may share common goals, they may need to apply different strategies based upon their personal factors. For example, if two investors are planning for retirement and one has a longer time frame to invest, he or she may be willing to utilize higher risk vehicles than someone who has a shorter time period to invest. Each investor must seriously consider their tolerance for risk, which includes their emotional comfort level in addition to financial abilities.
Developing Your Investment Strategies with Your Advisor
Upon defining your time horizon, funds needed to meet goals, and planned current and
future contributions, we can begin to determine appropriate asset classes and diversification strategies that will help develop the right portfolio for you.
There's also something more to consider: your tolerance for risk. For an investment strategy to work for you, it's imperative that you're comfortable with the risk you assume. Even though your financial situation may point toward a higher level of risk, your peace of mind might dictate a more conservative investment plan.
Stock investments offer the highest potential returns with the greatest amount of risk. Fixed income investments respond to changes in interest rates. Money markets have proven to offer stability; however, historically they have not produced returns much greater than the rate of inflation.
That's why it's important to spread investment dollars over various asset classes. While
diversification does not ensure a profit or protect against loss, a combination of money market, fixed income and equity investments can provide potentially higher returns than either money market or fixed income investments alone.
Asset allocation does not eliminate risk. However, it is a strategy to help you invest with discipline. Asset allocation is not only important in your stock portfolio, but in all of your investments, including as 401(k)s, IRAs and college savings plans.
Asset allocation is not a static strategy. To be effective, an asset allocation plan should be reviewed periodically. Also, any changes in your financial goals, lifestyle, time frame and financial circumstances, plus changes in market conditions, could necessitate revision of your asset allocation plan.
* ^ Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Determinants of Portfolio Performance II: An Update, The Financial
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved. Investing involves risk including potential loss of principal.