Best wishes for a happy holiday season from eXtension and the Cooperative Extension system. This is the time of year when many people like to “take stock” of their finances and make plans for the year ahead. Common year-end financial management tasks include changing payroll deductions for employer benefit and retirement savings plans, projecting capital gains or losses on investments, spending money set aside in flexible savings accounts, and adding up receipts for the current year’s income tax deductions.
Another helpful year-end “financial maintenance” activity is assessing changes in asset allocation during the previous year. Asset allocation is the process of dividing your money among several investment categories, called asset classes. An example of an asset allocation is 60% stocks, 20% bonds, 10% real estate, and 10% cash assets. The objective of asset allocation is to lower your investment risk by reducing portfolio volatility. Losses in one investment category are often offset by gains in another.
Research has shown that asset allocation is a major factor that affects investment performance. It is not what specific stock or bond that people invest in that matters the most over time, but, rather, the fact that they have money in different asset classes. These studies have been repeated numerous times, by different researchers, with similar results.
Various factors should be considered when determining a personal asset allocation strategy. They include a person’s investment objectives, the time horizon required to achieve financial goals, and the amount of money available to invest either as a lump sum or through regular deposits. Other important factors are an investor’s risk tolerance level 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 at the time. This is because only a portion of an investor’s money is in that asset class such as 60% in stock in the above example. 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 anyway.
Major asset classes for investing include large, medium, and small company growth stocks; large, medium, and small company value stocks, foreign stocks from both developed and developing (also known as emerging markets) countries; domestic and international bonds; real estate investments; and cash equivalent assets such as certificates of deposit and money market mutual funds.
Once you develop an asset allocation plan, remember to periodically recalculate asset allocation percentages and to rebalance, where necessary. Rebalancing means returning to your original asset class weightings and can be accomplished by either selling existing securities in an over-weighted asset class or putting new deposits into an under-weighted asset class. Some investment companies will even rebalance your portfolio for you on a regular basis (e.g., annually, on your birthday) if you request this service.
Rutgers Cooperative Extension has an Asset Allocation Spreadsheet at http://njaes.rutgers.edu/money to calculate current asset class weightings. The spreadsheet is pre-programmed using Microsoft Excel. Users simply need to replace the letters in the row placeholders with a description of their actual investments and list their current value (example: IRA Account, $10,000). The spreadsheet will total assets in each of the three categories (cash, fixed-income, and equity assets) and calculate the percentage weighting for each asset class. There is also a template to put the results into a pie chart.
Want to get a better understanding of your personal finances as the year 2010 comes to an end? Calculate your current investment asset allocation. Then use this information as a planning tool for the year ahead.
