Dec 21st, 2007
What is Asset Allocation and Why is it so Important?
Asset allocation is one of those things that financial gurus seem to talk about but not everyone understands. Basically it means how someone distributes their total portfolio among numerous classes of investment vehicles. Those investment vehicles can be stocks, bonds, cash, real estate, precious metals, collectables, and other things. For the most part, all I concern myself with is stocks, bonds, and cash, although I do own some real estate investment trust shares, which is kind of like owning real estate in stock form.
The reasons why asset allocation is important is simple: some investments do better than others and it’s pretty much impossible to predict which investment will do better in a given year. Asset classes produce returns in largely unrelated fashion (the domestic stock market going up might coincide with the international stock market going down and the bond market staying flat), so owning some of each is a way of reducing risk.
As always, there’s arguments for doing things in all sorts of ways. When I first studied the subject, I read about a formula somewhere that went like this: 110 minus your age equals the amount in percent of your portfolio to invest in stocks, and put the remainder in bonds, rebalancing every year as your age (and therefore your percentage in bonds) goes up. Therefore, if I’m thirty years old (which I may have been at the time), I’d put 80% in stocks, and the remaining 20% in bonds; the next year, when I turned thirty-one, I’d reduce the amount I have in stocks to 79% and increase my bonds to 21%. I didn’t consider the different categories of stocks (international, large cap, small cap, value, etc.) in those numbers, just going with the total stock market index.
This is not an unreasonable way to do things, but I decided that I really want a bit of an international exposure given the high rates of growth there the last few years, and I was probably managing more than is necessary for really small changes. What I’ve settled on is this:
75% stocks: 50% in the domestic total stock market index and 25% in the international total stock market index
25% bonds in either a GNMA bond fund or a total bond market index
Rebalance every year, possibly by just diverting new money entering the portfolio at a higher rate to whichever allocation is a bit small (if I ended up with a 48% domestic stock/29% international stock/23% bond ratio, I’d put more new money into domestic stock and bonds and a bit less into international stock) or possibly by actually moving existing assets around (watch those expenses, though!).
There are lots of different ways to do asset allocation; many books on the subject exist, and lots of different model portfolios do as well. There’s lots of reasons to do different type of allocations–for example, if I was in retirement, I’d likely want something closer to a 50/50 stock/bond ratio–but for me, right now, I like this allocation, and I’m sticking to it.
