Your asset allocation serves as a foundation from which to build your investment portfolio. An asset allocation identifies the types of investments and the proportion of each you plan to hold in your portfolio. At a very general level most investments are broken into three categories: stocks, interest earning, and real estate. Each of these broad categories can be broken down further into hundreds of different options. The two factors that usually drive an asset allocation are the timeframe in which you will need your money and your personal risk tolerance. Generally, we strive for a diversified portfolio that provides the highest rate of return for the level of risk we are willing to take.
The first step in developing an asset allocation is to evaluate your current situation and determine when the money you are investing will be used. Money that is needed in the short term should be placed in interest earning investments, not in real estate or the stock market. Interest earning investments, such as money market accounts and CDs, are secure but usually provide a rate of return below the rate of inflation. While it’s important to keep your short term money safe, too much in interest earning investments will stifle the long term growth potential of your portfolio.
Once your short term money has been secured, you can create a diversified portfolio that supports your investment timeframe and risk tolerance. A great way to diversify is through the use of low cost mutual funds. Mutual funds enable groups of individuals to pool their money to buy a large number of different companies or government entities. Mutual funds enable you to maintain a diversified asset allocation by investing in funds with different objectives. Consider selecting funds that invest in a variety of stocks and bonds in large, medium, and small companies within different industries and different geographical regions. Your goal is to maintain diversification so that when one category is doing poorly it may be offset by another category that is performing well. A diversified asset allocation allows you to spread out your risk so you don’t have dramatic losses if a given company or asset class performs poorly. Additionally, by spreading your asset allocation over a broad range of investments, you may have opportunities that would have been too risky in an undiversified portfolio.
Your asset allocation is the framework of your portfolio – establish a plan that meets your objectives and stick with it! Avoid making changes to your asset allocation based on emotional reactions to short term changes in the market. Over time, your portfolio will get out of balance due to fluctuations in the market. I recommend adjusting your portfolio by rebalancing on an annual basis. In addition to keeping your asset allocation on target, the need for rebalancing will result in selling stock when it is high and buying when it is low.