Asset Allocation: Critical to Your Investment Success

Asset allocation is a critical component of investing success. Both research and academic studies show asset allocation to be single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio. Other factors such as security selection and market timing account for a very small percentage of your investment returns. Unfortunately, the most important decision to achieving financial success is also the least understood.

What is asset allocation? Most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments among groups of similar assets. Ask investors to list the assets in which they would consider investing. Typical answers include "growth stocks", "bonds", "large caps", and sometimes "international stocks." But their diversification is limited to selection within one asset. For example, someone choosing to purchase technology stocks may invest in five or six companies ? but all within the technology industry. This reduces risk if one of the companies should fail, but is useless when the technology industry (or entire stock market) slumps.

Asset allocation goes beyond diversification to reduce risk across all type of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Investments and risk can be divided further into subcategories of stocks including large-cap, mid-cap, small-cap, value vs. growth, and international vs. domestic. Similarly, bonds can be divided into subcategories of short-term, and long-term, tax-free, high yield, convertible, emerging markets, floating rate, and international vs. domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even opposite to each other, both increases the return and lowers the risk of an entire portfolio. For example, international stocks are considered "riskier" than domestic stocks. Yet, we often see the prices of U.S. stocks go up on the same day prices of international stocks go down -- and vice versa. We call this negative correlation. Profits from one asset balance the losses from another. Combining international and U.S. stocks actually lowers investment risk by reducing daily price swings of our entire portfolio.

History demonstrates many markets exhibit similar negative price correlation. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents risk to any investor. Choosing to purchase only stocks, only bonds, or any single asset class increases the risk of losing money if that market underperforms.

The power of asset allocation comes from reducing risk while increasing returns. Reducing risk by combining multiple asset classes, however, is not a simple process. While each asset has its own unique measure of risk, many assets share similar price behavior (their prices go up and down together in any market). Combining such complimentary investments increase the risk of wild changes in price. Trade-offs between asset risk and expected return must also be considered. High yield assets typically experience high volatility, or large changes in price. These assets must be balanced by investments with lower rates of return to protect against large declines in value.

Successful asset allocation requires finding the proper mix of assets to balance reward with an acceptable level of risk. Proper allocation planning requires asset research and investment analysis. Fortunately, tools are available to assist the independent investor. Popular financial websites offers independent investors help with educational links and software to build portfolio allocations based on a survey of financial questions. For advanced investors, many books have been written to painstakingly explain the theory and practice of asset allocation ? also called MPT (Modern Portfolio Theory). Casual investors can purchase mutual funds specifically designed to automate asset allocation based on an expected retirement date. Pragmatic investors can explore the many financial planners and advisory services that offer asset allocation portfolios specific to their needs.

Consider your options carefully. Each solution offers its own set of advantages and disadvantages. Pick a style that closely reflects your own. Just how important is asset allocation? It's the single largest determinant of your long-term financial success.

Tim Olson

TheAssetAdvisor.com
Subscribe to our free newsletter.

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young, personal wealth management, and venture capital investing.

---

Stocks: Reduce Risk Yet Maximize Profits

It is important to note that every smart investor wants... Read More

Investing & Online Stock & Share Trading: Money & Risk Management - Atkinson Portfolio Planner (1)

This article was originally featured in Daryl Guppy's 'Tutorials in... Read More

Preholiday Trading

The Light Crude Continuous Contract closed at $66.13 a barrel... Read More

What Is A Fair Market Value, Really? If Youre Going To Trade, Be Sure Its Worth It!

I've been involved in online trading, specifically with stock and... Read More

Building The Foundation For Wealth

You wouldn't build your home on anything less than a... Read More

Creating a Financial Future - Putting Your Plan Into Action Part 1

This column has previously discussed "picturing the future that we... Read More

Investment Rowing

You have rowed a boat at some time haven't you?... Read More

The Conflict of Interest Game

Disgruntled investors are going after Wall Street once again, this... Read More

Looking For a Safe Investment? Try a Certificate of Deposit

If you are looking for a safe investment and you... Read More

Advice for International Investors on How to Safeguard Their Profits

What are the risks?Today, investors are increasingly turning to global... Read More

When NOT to Invest

Unfortunately, many investors who are seduced by the lure of... Read More

The Economy Is Not The Stock Market

Several days ago, the Commerce Department reported that May's factory... Read More

Short Selling for Investors

Shorts. Let's see. If there are shorts there must be... Read More

Day Trading the SP Futures with Initial S/R and the NYSE TICK

For instance, if the market moves up in the first... Read More

Can Your Annuity Do This?

Okay, so I can tell you I have sat in... Read More

College Savings Plans ? Are They The Best Choice For My Child?

College Savings Plans ? are they the best choice for... Read More

It Must Be Joe Cockers Market

Agonizing displays of poor theatrics failed to entertain my mind... Read More

Investing Psychology Today Requires All Traders to Awaken Their Speculator Minds

Stock trading strategies are as rampant today, as they were... Read More

The Myth of the Earnings Yield

AbstractA very slim minority of firms distribute dividends. This truism... Read More

Have You Ever Seen A Map of the World Turned Upside Down?

For those accustomed to viewing things a certain way, it... Read More

How to Choose the Right Share Class

You'll want to opt for the no-load or institutional share... Read More

Critical Investors Business Daily Responsibilities - If not Followed Could Cost You Millions!

When thinking about the investors business daily responsibilities in today’s... Read More

The Past Does Not Equal The Future: Mutual Fund Returns!

A way that investors get ripped off and in a... Read More

Guru Focused: Robert Olstein?s Short Sells

While it is rather rare that value gurus sell stocks... Read More

It?s Never too Early to Start Investing!

Remember the old saying, "never too late to start"? Well,... Read More

Begging Your Trust in Africa

The syntax is tortured, the grammar mutilated, but the message... Read More

Going Offshore For Asset Protection

There are a number of key reasons why individuals and... Read More

Franchise Opportunity Sellers Beware; franchise buyers lie on forms?

It seems completely absurd that franchise buyers lie about their... Read More

How to Use Annual Report

There are many steps in calculating the fair value of... Read More

Types of Investment

The word 'investments' is one that most of us are... Read More

Landlording 101, Tricks of The Trade

Looking Inside Your Tenant's Mind Basic Mind-Reading Report 101 for... Read More

Going Against the Conventional Investment Wisdom

First of all, I want to give everyone the disclaimer... Read More

Annuity Investment Guide

While there is not a lack of information on annuities,... Read More