We’ve already established that trying to get in and out of the market at the right time is a losing battle. How, then, should you be managing your long-term investment portfolio? Asset allocation is the first step.
Put in layman’s terms, asset allocation is how you divide up your portfolio into stocks, bonds, and cash type investments. That decision is very important. Studies have shown that over 90% of the variance in portfolio returns may be determined by how you allocate your money. What is the proper allocation for you?
That depends on a variety of factors. Time horizon is probably the most important determinant in the process. Generally, the longer you have to achieve your investment goal, the more you can invest in stocks. Consequently, young people investing for retirement should be pretty heavily in stocks. As you age, your allocation to equities should generally come down as you shift to less volatile investments, such as bonds, and cash. Another factor affecting the asset allocation decision is your risk tolerance. Simply put, this is how you respond to the ups and downs of the market. The whole idea of asset allocation is to find the mix of stocks, bonds and cash that will offer the best return for the level of risk you are willing to take. Investing in a mix that is too volatile may cause you to make bad decisions at the worst possible time, such as selling out when the market has a severe downturn.
The idea is to design a portfolio that you can stick with under all market conditions so that you are not tempted to do something that could jeopardize your long-term investment results. Other factors that will affect the asset allocation decision are the size of the portfolio, income needs from the portfolio, and other assets, such as real estate ownership. Just remember next time you are looking at your 401(k) statement, first determine your asset allocation, and then select the right funds. Next month we will talk about how to do that.