Like it or not, the one investment decision you cannot avoid is asset allocation. Whether you invest aggressively or choose to keep you money safely on the sidelines, any investment choice you make, whether active or passive, is an implicit asset allocation decision. It is also probably the most important investment decision you face.
Too often, people back into asset allocation by default, or according to some arbitrary guideline. It is a decision that deserves more attention than that. In approaching this decision, it's wise to keep the seven rules below in the front of your mind.
Key rules for asset allocation
1. Think allocation over selection. For all the air time that financial programs give to individual stocks, asset allocation is likely to matter more than any single stock selection you will ever make. That's because in a diversified portfolio, any one stock can only make so much difference, and the performance of the stocks you own as a group is likely to be heavily influenced by their asset class characteristics. So, while the earnings details and management rumors surrounding individual companies provide daily fodder for the Wall Street media, don't let all the noise distract you from the bigger picture.
2. Define asset classes carefully. For better or worse, the securities you buy to represent each asset class should have roughly the same risk and reward characteristics of the asset class in general. This means that you should not define your asset classes too broadly or imprecisely. For example, thinking of stocks as a single asset class is too vague given that small cap stocks may perform very differently from large cap stocks, and stocks from different countries have widely differing returns. Also, many investment consultants insist on classifying hedge funds as an asset class, even though hedge funds are just a legal structure that can contain any number of very different investment approaches.
3. Know the role of each asset class. Everything you own should have a specific purpose -- for example, some investments are designed to provide growth, others to yield income, still others give you security and liquidity. It is important not to blur the lines, such as by buying low-grade bonds to increase your income yield if the intended role of your bond portfolio is to provide stability.
4. Beware of limited histories. The performance history of an asset class can be a useful guide to what those investments are capable of, in terms of both risk and reward. However, do not get lulled into thinking the past is a perfect road map to the future, especially where newer asset classes are concerned. Not only might their limited histories provide an incomplete picture of the full range of market conditions possible, but as an asset class gains popularity and attracts more money, over-investment can deteriorate its risk and reward characteristics.
5. Don't become too passive. A common approach to asset allocation is to stick to a set policy allocation, such as 60 percent stocks and 40 percent bonds. The problem is, no single allocation is likely to be right for all valuation and interest rate environments. It makes sense to have some parameters, so your portfolio does not veer toward being too aggressive or too conservative, but consider setting allocation ranges that allow you to adjust to changing conditions, rather than sticking to one allocation no matter what conditions dictate.
6. Know the dangers of trying to time the market. The opposite extreme to a passive allocation approach is market timing, where you make short-term allocation moves to try to be in and out of the market on the right days. This is a highly risky approach. Since markets can act irrationally in the short-term, trying to predict day-to-day moves is pure speculation. Studies have shown that being out of the market on just a handful of the wrong days can seriously erode your returns.
7. Don't assume too much. Asset allocations are often set based on some expectation of what normal returns will be, but today's low interest rates challenge those assumptions. With bond yields around 2 or 3 percent, and savings account rates at less than 1 percent, does it make sense to assume those asset classes will provide their customary returns of 5 or 6 percent for long bonds and 3 or 4 percent for cash equivalents?
Asset allocation is a process of deciding between alternatives. Your approach to it should acknowledge that it is a long-term decision, but one for which the dynamics involved change over time. Therefore, you need to avoid the extremes of either making too many adjustments to your allocation or being totally passive with it.
More from MoneyRates.com: