Asset allocation is a term used a lot by financial professionals, who use fancy words that many investors don't understand. Asset allocation simply means how your money is split between different types of investments.
It's very important for investors to have a proper asset allocation because the market goes through cycles. For a while, market experts might love small-cap stocks, and then they hate them. Traders pile into technology stocks for a few months, then they dump them. I'm never going to be smart enough—or lucky enough—to know when we should be all in technology or another group of stocks.
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Instead, investors should be exposed to a number of different asset classes at all times. Being diversified smooths out the bumps in the market over time. It also reduces the chances of sustaining significant losses by being too concentrated in any one sector.
That said, you do want to be strategic. Sometimes certain types of investments are more attractive than others. In those times, you should continue to have exposure to many types of asset classes, but you'll want to put more money in things that look most promising and less in things that don't look as good.
But being strategic doesn't mean trying to time the market. About six weeks ago, concerns about Greece flared up again causing stocks to drop. Then came worries about increasing the U.S. debt ceiling. At that time, it seemed that bonds were the place to be, and stocks were out of favor. Then all of a sudden, things turned around.
Even with all the volatility, many types of stocks are beating bonds. If you want a sure thing, you can buy treasury bonds. The 10-year treasury bond currently pays 3 percent interest for the whole year. If you seek a higher return, you'll have to consider other investments such as stocks, especially if they continue to perform as they have for the rest of the year. This way, you get the combination of the lower returns of bonds and higher returns of stocks. That means your average return usually ends up being higher than what you can get by owning only bonds. Plus, the bond portion dampens the volatility that comes with stocks.
Developing your asset allocation is tricky. Many people say that if you're 60 years old, that means you should have 60 percent of your investments in bonds and 40 percent in stocks. Take your age, and that's the portion you should have in bonds.
But that's not good enough. Not only do you have to decide how much you should put in stocks and bonds, you have to divide your money among the different types of stocks and bonds. Your allocations in different kinds of stocks and bonds depends on how much risk, or volatility, you can handle. You also have to consider the time horizon of your goals. If you have a long time horizon, such as saving for retirement, you may be more willing to take risks with aggressive assets like stocks to achieve higher returns. As you get closer to your goal, you can shift a portion of your investments into less-volatile assets like highly rated bonds and CDs.
Once you establish your asset allocation and pick the best funds for each asset class, stick to it. If your situation or time horizon changes, you can adjust your asset allocation. You need to regularly rebalance your portfolio, because market conditions can evolve every few months and cause your allocations to get out of whack with your risk tolerance.
For example, if health care funds have outperformed, you would sell some of those through rebalancing and buy a fund that has underperformed. But don't make changes every day or let emotions take over when you see certain investments go up or down. Set a schedule to review your portfolio twice a year to make sure your allocations match your risk tolerance.
When you use the right asset allocation, you'll improve the odds of achieving success.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.