WHAT IS ASSET ALLOCATION?
MBA Series #1
“Don’t put all of your eggs in one basket.”
The beginning of the year is portfolio rebalancing time for investors. I write a lot about investing as I believe it is an achievable path to long term wealth. If you don’t know what asset allocation is or much about investing at all, then this article is for you.
Modern Portfolio Theory is the science that drives most of the writing about investing today. As I put the finishing touches on the university class I’m teaching this winter in Investments, I’m going to share some of the basics with you; FOR FREE!
Tried and True Investing
Diversification in investing means don’t put all of your money in one investment or one type of investment.
When that investment goes down, there goes the value of your invested assets-down.
Buy different types of investments, so that when one goes down in price, the others may go up, or at least remain stable.
Diversification smooths out the ups and downs of the value of your investments.
For example, it is rare for bonds and stocks both to go down at the same time. During the past decades bonds have outperformed stocks, an historically unusual occurrence. Over long periods of time stocks have outperformed bonds, but a combination of both asset classes reduces your portfolio volatility.
There are all types of asset classes such as, international stocks, country specific stocks, small cap stocks, commodities, real estate, corporate bonds, government bonds, international bonds and many more. All of these types of assets can be bought as individual holdings, or combined in mutual funds and exchange traded funds (ETF). But, you don’t need to worry about the wide variety of asset classes unless you are passionate about investment management. You can obtain a satisfactory amount of diversification with just two ETFs or mutual funds.
Asset Allocation means selecting specific asset classes and choosing the percentage amount invested in each asset class. The chart above illustrates a simple asset allocation model.
Simple Portfolio Management
The research abounds that a basic asset allocation of a certain percent in stock investments and a certain percent in bond investments has led to long term wealth creation.
With annual rebalancing to make sure the percentages in each asset class remain in alignment with your stated preference, you can grow your assets with little time spent in managing them.
Index funds and ETFs are perfectly suited to a simple and effective portfolio management approach. The two asset portfolio shown in the chart above combines a world stock market index ETF with a total US bond fund. Depending upon your age and risk tolerance, place more or less in each asset class.
Rebalance your portfolio at the end of the year to get back to your originally selected asset allocation. In other words buy or sell from each holding to get back to the desired percentage amount invested in each fund. Paul B. Farrell of Market Watch has a wonderful series called the Lazy Portfolios with several asset allocations and performance metrics. For more ideas on this topic, it’s worth a read. The ten year annual returns of the 8 Lazy Portfolios ranged from 4.8% to 6.8% versus a ten year return of the S & P Index of 2.86%.
Consider this easy approach to investing to grow your wealth over time. This method is ideally suited for use with a workplace retirement fund.
For more on this topic, subscribe to my Wealth Tips Newsletter and receive a free ebook, 20 Minute Guide to Investing. (Sign up on the right)
Caveat; This article is for information purposes only and is not a recommendation to buy or sell any specific securities. For investment advice see your own personal advisor.
If You Can’t Get Enough Asset Allocation, Here’s More
Doug Warshau wrote about Asset Allocation for People in their Twenties at Sweating the Big Stuff
The Absolute Importance of Asset Allocation at Money Help for Christians
My Personal Finance Journey shares his Asset Allocation
For those asset allocators out there, what is your asset allocation and why?