At its simplest, asset allocation is how you divide the money you have for investing between asset classes – stocks, bonds, real estate and cash.  In doing this you are likely to reduce your risk and increase your returns.  Choosing an asset allocation that is suitable for any individual is based on historical rates of return and the individual’s appetite for risk.  How you do this is based on several factors including your financial goals and needs, tolerance for risk and your time horizon.

Unfortunately historical returns do not always repeat and asset allocation is as much about probabilities and unknowns as it is about statistical financial formulas.  One cannot help but to think about Long Term Capital Management’s implosion in 1998 as well as the horrendous returns the banks appear to be getting from those wonderful mortgage investments.  However, as long as the investments are diversified the returns should move to the average of the asset classes.  The observation regarding mortgages and LTCM was that there was simply no diversification.  Failed banks, for the most part, made large bets on mortgages as opposed to staying diversified, LTCM made huge bets on foreign debt and currencies with hardly a whiff of diversification.  ( see footnote on bank failures )

Asset allocation is based on the idea that in different years a different asset is the best-performing, and that it is difficult to predict which asset will perform best in a given year and therefore no one assets class should dominate your holdings.

The Importance of Cash

A portion of any portfolio should be in cash or an equivalent so you can quickly access it if you need it.  Selling stock should be timed to the market not based on an emergency.  Cash is also a hedge against a downturn in the market.  It can sit in a safe place earning interest if you do not need it.

A monthly savings plan to put money into an interest-bearing bank account or a money market fund is an ideal method to build wealth.  Bank savings accounts, money market accounts and certificates of deposit are all suitable cash equivalents.  When your cash reserve is adequate, you can begin to tap this fund and invest in a mutual or index fund on a regular basis.

In doing this you are using dollar cost averaging as your investing strategy.  Putting a fixed amount at a fixed time into an investment will let you pay an average price that is lower than the average price of the security at the time.  Why?  Because when the share price is lower, you buy more and when the price is high you buy less. 

Dollar cost averaging can be employed as tactic to purchase bank certificates of deposits as well.  As your cash accumulates in a temporary vessel such as a high yielding savings account or money market account, a portion of those funds can be transferred to purchase higher interest rate certificates of deposits.  During this process, varying term bank CDs can be purchase for even more diversification.  Buying bank CDs with different maturities is referred to as a CD ladder.  Dollar cost averaging with a CD ladder is ingenious. 

Stocks

The “rule” that comes to mind in allocating a portfolio into stocks is that the younger you are the higher the percentage that should be in stock.  While this might be true, other factors have to be considered.  Your goals for the money and the time frame you have to accumulate what you need and your risk tolerance are just as important.

Retirement may be one goal, but accumulating $100,000 to pay for college for a child or start a business might be another.  Moreover, even elderly investors may have a long-term horizon for their goals.  Why limit the time horizon for an investment to your lifetime if the goal is to provide for the next generation or fund a project at the college you attended?

The most successful investor does not constantly shift money around in their portfolio but holds investments for a longer time.  However, life does change and the percentage you have in stocks today could change for good reason.  As you build up more cash in savings, it will increase as a percentage of your overall portfolio.  Putting more of it into stocks or bonds is an example of balancing your portfolio to maintain the asset allocation that you desire.  Similarly, if you set up an automatic investment plan so you can dollar cost average, the percentages you have allocated in stocks and bonds will change over time.

Bonds

No one should have all of his or her money in the stock market.  When the stock market suffers, having money in bonds can soften the impact on your total return.  Bonds will help as your buffer to equity market losses.  The amount of money you have in bonds is a very individual decision but diversification should be the underlying theme.  If you are not comfortable with risk and the swings of the stock market, hedging your position and putting a bit more in bonds may make a lot of sense and help you sleep at night.  In general, as investors get closer to retirement and the day they need to begin to live off their portfolio, they move a larger percentage into bonds and cash.  Bonds can provide a steady income stream in just about any market condition but should not be used exclusively. 

When personal finance experts remind readers to be well diversified, they are urging you to review your asset allocation and check to see if the mix you may have set up a year ago, or more, is still right for you.  The fine art of balancing a portfolio can seem like a homework assignment that you would rather avoid.  If this is how you feel about it, try working with a financial advisor.  You can also let stock and bond funds, in particular index and exchange-traded funds, make balancing your portfolio an easier proposition.

Footnote Regarding Bank Failures and the Lack of Diversification – The largest bank failures and troubled banks in the past two years are almost exclusively tied to mortgages and hence were not involved in good asset allocation or diversification.  Washington Mutual was a big mortgage originator prior to purchasing Long Beach Mortgage which was one of the largest subprime lenders; there was no surprise it was headed for disaster and into the arms of Chase.  IndyMac was always a mortgage company first that just happened to have a bank attached to it.  Downey Savings and Loan was one of the largest originators of the disastrous option ARM loans.  Its twin in the southeast was BankUnited and it just went under ( it presently has  new owners ).  Wachovia’s shaky footing and subsequent forced sale had a lot to do with their the ill advised purchase of Golden West Financial in 2006 which operated predominantly in the west coast and originated option ARM home loans nationwide.  And let us not forget two of the big players in mortgage originations and sales of securities were Bear Stearns and Lehman Brothers.

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