Asset Allocation Provides Diversification and Reduces Risk
Asset allocation is the process of dividing your money among several investment categories, called asset classes. An example of an asset allocation is 50% stocks, 30% bonds, and 20% cash assets. The objective of asset allocation is to lower investment risk by reducing portfolio volatility. Losses in one investment category are often offset by gains in another.
Many investment professionals use a "Periodic Table of Investment Returns" chart from Callan Associates or Ibbotson Associates to illustrate that various asset classes fall in and out of favor. For example, large company growth stocks were the top asset class from 1995-1999. These charts, comprised of dozens of colorful squares, each representing a different asset class, clearly show how one year's asset class "winner" can be next year's "loser," so you invest in them all.
Research clearly indicates that it is futile to practice market timing and try to dart in and out of different asset classes trying to catch their highs and avoid their lows. Rather, investment returns are severely reduced by missing the stock market's best trading days. If someone stayed in the market between 1998 and 2000, their return over this period was 41.4%. If they missed the 10 best trading days of each year, however, their return was -41.7%. It is important to remain invested in both bull and bear markets.
Research has also shown that asset allocation is the major determinant of investment performance. It is not what specific stock or bond you invest in that matters the most over time, but, rather, the fact that you have money in different asset classes. These studies have been repeated numerous times, by different researchers, with similar results.
Here is an example that illustrates the effects of portfolio diversification over time. Investor A places $100,000 in an investment earning an average annual return of 8%. After 25 years, the investment grows to $684,848. Investor B divides the $100,000 equally among five investments with varying rates of return. One investment loses everything and a second earns nothing. The other three earn average annual returns of 5%, 10%, and 15%, respectively. At the end of 25 years, the diversified portfolio will grow to $962,800, or over $275,000 more.
Various factors should be considered when determining a personal asset allocation strategy. They include your investment objectives (example: college savings for a young child), your time horizon for each goal, and the amount of money you have to invest. Other important factors are your risk tolerance and investment experience, age, and net worth.
The downside of asset allocation is that a diversified portfolio never earns as much as the "hottest" asset class (e.g., small company stocks) at the time. This is because only a portion of your money is in that asset class. Of course, nobody knows in advance what the "hot" asset class of a given year will be, so this information can only be viewed in hindsight.
Major asset classes that can comprise an investment portfolio include large, medium, and small company growth stocks; large, medium, and small company value stocks, foreign stocks from both developed and developing (a.k.a., emerging market) countries; domestic and international bonds; real estate investments, such as real estate investment trusts (REITS); and cash assets such as certificates of deposit and Treasury bills.
When assembling an investment portfolio, it is advisable to select investments with a low correlation coefficient with respect to each other. A correlation coefficient is a number that indicates the degree to which the return on two different types of investments is related. Coefficients can range from -1.0 (perfect negative correlation) to +1.0 (perfect positive correlation). The lower the coefficient between two investments, the less likely they are to perform in a similar manner.
It is important to periodically recalculate asset allocation percentages and to rebalance, where necessary. Rebalancing can be done by either selling existing securities in an over-weighted asset class or putting "new money" into an under-weighted asset class.