A Rational Guide to Asset Allocation
May 17, 2010
| MoneyRates.com Senior Financial Analyst, CFA
With the stocks on quite a run throughout 2009, many people got the itch to get back into the market. And that's where the trouble begins.
Too often, people jump from one asset class to another in reaction to things that have just happened. The financial crisis and the resulting bear market scared investors out of stocks and into bonds and savings accounts, while the subsequent run-up in stocks lured more people back into the market.
This approach is understandable emotionally--it's hard to watch your stock portfolio tank and not feel the urge to pull your money into that nice, safe savings account--but it can be disastrous financially. Don't let your emotions govern your asset allocation. You need a rational approach.
Rational Approaches to Asset Allocation
There are different schools of thought about what constitutes a rational approach to asset allocation, but here are some approaches that are all more constructive than responding to emotions about the market:
- A static approach. Taking buy-and-hold to an extreme, you could put a predetermined dollar amount or percentage of your money into different asset classes, then simply keep each in its own separate compartment, not interacting with one another.
- A rebalancing approach. Price fluctuations cause your asset allocation to change over time. If stocks are hot, what might have started off as a portfolio with 50% stocks might become a portfolio with 65% stock. A rebalancing approach would have you periodically adjust your allocation back to a certain target percentage for each asset type. This rebalancing forces you to sell assets that have appreciated in value and put money into assets which have declined or appreciated more slowly. This can reduce your exposure to market extremes.
- A valuation approach. More sophisticated investors might make allocation decisions based on a valuation model. This means that you do the hard work to determine an investment's "true worth" to the best of your ability. You wouldn't get caught up in the latest market ups and downs: if the fundamental facts that led to your valuation stayed the same, you could keep the allocation in place, or buy or sell if you think the market is undervaluing or overvaluing the asset.
Matching Assets with Their Roles
Whichever approach you take to asset allocation--including a combination of the above--it should be based on matching the right investment to your needs.
- Stocks. Stocks fit with the need to grow your portfolio over a very long time horizon. Even over periods of ten years or longer, stock returns can be highly unpredictable.
- Bonds. Bonds can help you meet income needs over a period of several years and stabilize your portfolio to avoid large swings. Not all bonds are low-risk, though. Concentrate on high-quality bonds (such as U.S. Treasuries) unless you want to cross the line into stock-like risk.
- CDs. If you have a series of very specific cash needs over the next few years, consider matching CD maturities to those needs.
- Savings or money market accounts. These are good for near-term cash needs and emergency funds. See if your usage of the account would qualify you for a money market account, since money market rates are on average higher than savings account rates.
If you're like most people, you'll find that you have a variety of needs that call for a combination of asset types, and these needs will change throughout your life. By fitting each type of investment into your asset mix, you'll not only target appropriate investments for each individual need but also achieve some measure of diversification.
