What is asset allocation, and how can it help my investment strategy? You may have heard about Harry Markowitz’s Nobel-prize winning work on “Modern Portfolio Theory”. It’s been long known that diversification is the key to maximizing returns while minimizing the risk. To use an example, if you picked one “good” stock, you have a good chance of getting decent return on your investment over time since this stock probably did well in whatever analysis you chose. However, there is the chance that the company you chose can go out of business completely, or the stock could significantly decrease in value. It may be a relatively small chance, but if you spend your life savings – let’s just say $500,000 – on this one stock, it would be devastating. Obviously, having $10,000 in 50 different stocks is less risky, since if one stock goes under, you don’t lose everything.
Asset allocation goes a little deeper. It has been shown that investing across asset classes can further reduce risk and reduce volatility in a portfolio. In other words, you won’t see all the high upswings and downswings in a portfolio from day to day or month to month. So, what is an asset class? Of all the securities out there, most can be grouped into broad categories. For example, securities are often grouped by the size of the company, whether it is foreign or domestic, whether it is an equity or debt instrument (bonds), and even cash and cash equivalents have a group.
The idea is that since different assets classes do better than others from year to year as market conditions change and also for other often unpredictable reasons, it is good to have money spread over the different asset classes so that you’ll have some money in the best performing classes each year. In other words, large growth stocks may perform better than other asset classes this year, but may perform relatively poorly next year. This keeps your portfolio more stable. Remember, the goal is to maximize returns while minimizing risk.
Of course, how much you allocate to each asset class should be based on your risk tolerance and your individual needs and goals, and should certainly be reevaluated as your lifestyle and goals change over time, in addition to changes in your income and expense levels. Financial professionals should also be able to determine what is appropriate for you and to evaluate your portfolio regularly to ensure that rebalancing is performed as needed. Communication with your financial advisor is key to having the right balance for each stage of your life.