IFYF Monthly Investing Messages

Personal Finance August 03, 2015 Print Friendly and PDF

 

 


 

Investing For Your Future Monthly Message

August 2015

Barbara O’Neill, Extension Specialist in Financial Resource Management

Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

Asset Allocation Basics

 

Asset allocation is the process of diversifying an investment portfolio among different categories of securities called asset classes. For example, 50% stock, 30% bonds, 10% real estate investments, and 10% cash equivalent assets (e.g., money market funds and certificates of deposit). The goal of asset allocation is to lower investment risk by reducing portfolio volatility. In other words, investors hope that losses in one asset class will be offset by gains in another.

 

Because investors don’t know how various investments will perform, they use asset allocation to hedge their bets.  Of course, there is a trade-off. A diversified portfolio will generate a lower rate of return when compared with a single “hot” asset class. Unfortunately, investors never know which assets will be the best performers in advance.  Asset allocation provides a reasonable rate of return with less volatility.

 

Each year, a company called Callan Associates updates a colorful chart that shows how various asset classes have performed during the past 20 years.  The chart, which looks like a patchwork quilt, shows that the best performing asset class typically changes from year to year.  One year’s winning asset class can be next year’s loser, so it is prudent to invest in them all.

 

Note that international investments are often suggested by financial experts.  This is because U.S. and world markets do not always move in the same direction.  Foreign country investments (e.g., international stock mutual funds) provide diversification and exposure to a majority of the world’s equity market.

 

Research shows that asset allocation is one of the most important decisions that investors make.  Asset allocation determines about 90% of the variation in return between portfolios.  In other words, it is more important that an investor own some stock than, say, the difference between Coke and Pepsi stock.  These studies have been widely repeated with similar results.

 

The process of asset allocation has several associated terms. A correlation coefficient is a measure of how to investments move together.  Beta measures the volatility of an investment in relation to the market.  Standard deviation measures the volatility of an investment and “Efficient Frontier” is the optimum combination of assets for a given rate of return and level of risk.

 

These are several key factors to consider when determining a personal asset allocation strategy.  They include your time horizon for financial goals, the amount of money you have to invest, your age and net worth, and your risk tolerance and investment experience. How do you get started?  Follow this six step process.  First, define your goals and time horizon.  Then assess your risk tolerance and the asset mix of your current portfolio.  Next, create a target portfolio and purchase specific investments to get the proper weighting of asset classes.  Finally, review and rebalance your portfolio periodically.

 

Asset allocation works best over time.  It is also important to diversify investments within each asset class.  Retirees may want to keep several years of expenses in cash for use during market downturns and invest the balance of their portfolio in stock to hedge inflation. Stick to your asset allocation model, in up and down markets, unless personal circumstances change.  Also be prepared to rebalance your portfolio when asset weight percentages change by a certain amount and don’t get overly weighted in one company or industry.

 

 With limited funds, asset allocation can be achieved with just one mutual fund.  Lifecycle funds typically offer three to four portfolios from which to select one with different mixes of stocks, bonds, and cash from conservative to aggressive (more stock) asset allocations. A target-date fund is similar to a life-cycle fund except that it is structured to gradually and automatically grow more conservative as the target date (e.g., 2040) approaches. Investors typically select a target date portfolio to coincide with their planned retirement.

 

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