Contributed by: Angela Palacios, CFP®
Asset allocation is like the foundation of your house. It is the most important structural part of your investment process. Without it, your home or your financial plans could become extremely unstable.
Many investors either become paralyzed and unable to make decisions, or make decisions by constantly chasing the recent past and, thus, earning dismal returns. To avoid those mistakes, one of the first and most important steps in investing is determining your Asset Allocation.
An Asset Allocation Model is usually the outcome of the financial plan you complete with your investment professional. Its goals are normally to identify the mix of assets that best balances an investor’s desire for return with the desire not to take undue risk. Studies have shown that asset allocation decisions account for a significant amount of the variation of total returns, while security selection accounts for a relatively small portion of the variability of total returns. The most notable study was done in 1986 by Brinson, Hood and Beebower. The researchers found that the asset allocation policy explained 93.6% of the average funds’ variation over time.
In its simplest form, Asset Allocation is the percent of stocks, bonds, and cash you would own in a world of normal valuations. Generally, allocations with more stocks than bonds would be in the “High Risk/High Return” area of the line on the “Efficient Frontier” chart below.
Disclosure: The “Efficient Frontier” is a concept derived from Modern Portfolio Theory. According to the theory, it is possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk.
This chart can change greatly depending on the time period you use to draw it. The following is how the above chart varies in actuality decade to decade.
In the 1960s, 1980s and 1990s stocks significantly outperformed bonds. While the 1970s and the 2000s show a much different story. Not only were stocks an underperforming asset, but the risks involved were very high using standard deviation as our risk scale. (The Weiss Report, Vol. 13)
While careful Asset Allocation can help make your investment portfolio structurally strong, unlike the foundation of your house, shifting investments can be a good thing. In practicality your Asset Allocation, rather than being static, can be changed tactically to reflect current market conditions as shown above. Watch future posts to find out more about using asset allocation and other investment strategies.
Angela Palacios, CFP® is the Director of Investments at Center for Financial Planning, Inc.® Angela specializes in Investment and Macro economic research. She is a frequent contributor The Center blog.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Asset allocation does not ensure a profit or protect against a loss.