Most of the investment coverage you're seeing is focused on the wrong thing.
Television shows and online forums that cover the financial markets like to offer hot tips and discuss which stocks are the day's big winners and losers. Instead, they should be focusing on the one thing that is generally a much greater determinant of investment success -- asset allocation.
Investment analysts have argued for decades about precisely how important asset allocation is to a portfolio's return, but they all agree on one thing: Asset allocation is a dominant factor in determining the relative success of one portfolio as compared to another. In short, while stock-picking may provoke spirited commentary and debate, asset allocation is an investment fundamental you can't ignore.
Understanding asset allocation
To understand the nature of asset allocation, think of two people going to a grocery store -- one person heads into the store with a short list of ingredients for a specific recipe and the other fills a shopping cart with a week's worth of provisions.
The short list of ingredients is designed to produce a specific dish, which may or may not be what someone else wants. The week's worth of provisions may not be geared toward preparing any one specific recipe; however, it is more likely to provide a well-rounded diet for a variety of people.
Another way to explain the difference between individual securities and asset classes is to think of individual securities as the ingredients and asset classes as the shopping cart.
In this analogy, individual securities belong to asset classes, individually or in small numbers. Individual securities are not likely to be fully representative of their asset class. In small numbers, individual securities are likely to perform significantly differently from the asset class as a whole, for better or worse.
Asset classes are like the full shopping cart. An asset class is a representative range of holdings of a type of security, whether it be bonds, U.S. stocks, foreign stocks, etc. Their performance as a group is likely to depend on how that type of security did overall.
5 basics of asset allocation
- Asset-allocation strategies can be passive or active
You can choose a set-it-and-forget-it approach to asset allocation, where you maintain a set mix of different asset classes. This is a passive-asset-allocation approach, and the only intervention needed is to rebalance the mix occasionally back to the target. If you are shooting for risk/reward characteristics consistent with a specific blend of asset classes, a passive approach is most likely to produce those characteristics over time.
In contrast, active-asset-allocation strategies involve making significant changes to the mix according to your investment outlook. If you think stocks are going to have a great year, you would move to a heavier allocation in stocks. If you thought the stock market was heading for a bear market, you would cut back to a lighter allocation. Those active decisions could significantly alter the risk/reward characteristics of your portfolio, for better or worse.
- Asset-allocation strategies should align with your long-term goals
Your asset-allocation approach should be in sync with your long-term investment goals. If you are investing for something far off in the future such as retirement in 20 years, you should be heavily weighted toward higher risk/reward investments like stocks. With a long time horizon, you can wait out some of the ups and downs of market cycles, and you are likely to need growth to keep your investments ahead of inflation.
In contrast, if you have near-term needs, you would be likely to feature an investment strategy more geared toward stability and liquidity to make sure money is readily available when you need it. This would call for a more conservative asset allocation.
- You can do it yourself or have asset allocation managed for you
You can set your asset allocation yourself by buying separate securities or funds of different asset classes in a proportion that represents your target mix. That would leave you with the responsibility of making any changes necessary for tactical reasons or to rebalance to your target.
There are also professionally managed asset-allocation funds that either maintain an allocation in line with a specified target or adjust the allocation over time in keeping with a particular goal. Target date funds, which are popular in 401(k) plans because they set an allocation based on when the participant plans to retire, are an example of the latter approach.
Both retirement plans like 401(k) programs and online brokers are likely to offer a choice between individual asset-class products that will require you to make asset-allocation decisions and asset-allocation funds that will produce an asset-allocation mix for you.
- There are many types of assets from which to choose
Stocks, bonds and cash are the three basic asset classes commonly used; but there are a host of other choices such as real estate, commodities, crypto-currencies, etc.
There are also subgroups of the three basic asset classes such as government vs. corporate bonds, small company vs. large company stocks, domestic vs. foreign securities.
Any group of securities that share similar characteristics and are influenced by factors distinct from other groups of securities can be considered an asset class.
- Historical returns of asset classes have limits
Asset-allocation decisions are often based on historical risk/reward characteristics of an asset class. Not only does history show past risk/reward characteristics for an individual asset class, but it shows how different asset classes have interacted with each other.
Part of the value of owning different asset classes comes from non-covariance, which is the extent to which different asset classes tend to go up or down at different times. Having some part of your portfolios doing well while other parts are struggling can smooth out some of the volatility in your portfolio.
History is a helpful guide to what an asset class is capable of, but it should not be thought of as a reliable road map to future performance. Risk and return characteristics can depart from historical norms over extended periods of time, and non-covariance between asset classes can be changeable as well.
History is particularly unreliable when it comes to relatively new asset classes. A type of investment that has not been around for decades has probably not been tested over a full range of conditions, and growth in the popularity of an asset class can impact how it performs.
The thing about asset allocation is that, besides being important to a portfolio's performance, it is also a decision you are going to make one way or another. With that being the case, it is much better to arrive at an asset allocation via a conscious investment strategy than simply by default.
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