How can a regular investor choose the right investments for his or her personal portfolio? There are tens of thousands of individual stocks, individual bonds, exchange-traded funds, open-end mutual funds, closed-end mutual funds, and unit investment trusts. It’s daunting. You need to consider a framework or strategy to guide the process. Asset allocation, defined as choosing the proportional mix of stocks and bonds and then the types and proportions of those broad securities within your portfolio, can provide that framework.
We might want to think that we or our adviser can choose just the right stock and just the right time to enter the market. Likewise, we might think that we or our adviser can choose just the right time to sell out of the market. The myth that security selection and market timing are the keys to investment success drives many people to make poor investment decisions. Multiple studies have shown that this is not so and that asset allocation is actually responsible for over 90% of portfolio return, far surpassing the value of individual security selection or market timing.
The goal of asset allocation is to reduce risk and create diversification by dividing assets among the major classes and sub classes of stocks, bonds, and cash. Each asset class has different levels of risk and return and behaves differently over time. While this may not produce the highest return, it will be more likely to protect against significant loss caused by overexposure to a particular asset class or sub class. Think back to the demise of the stock market in 1929, 1981, 1987, and 2008. Investors concerned with only the highest possible return and therefore invested 100% in stock were severely damaged and experienced a longer road to recovery.
Choosing an asset allocation is one of the most important decisions that investors make. We believe your allocation should be goal/needs driven. In practice this means that, using expected rates of return, you would choose the asset allocation that produces the return you need to accomplish your goals. Risk must also be acknowledged and acceptable. Asset allocation for a short-term goal, such as college funding for a middle school student will be more conservative than the asset allocation for a long-term goal of retirement in 25 years. With a 25-year time horizon, time is on your side and you probably don’t need to obsess over the short-term fluctuations in the stock market. Rebalance your portfolio to its original mix when any given asset class moves more than 5% from its original value to help ensure that you do not become overexposed to any one market segment. Such rebalancing also forces you to implement that time honored investment strategy of buying low and selling high.
Investors are often driven to make emotional decisions that are often wrong for their long term success. This strategy may not be as exciting as finding the next hot stock or using intuition to time the market but it has proven to be a reliable strategy for more stable investment returns.