Asset allocation is a theory, as well as a method, used to set the foundation when constructing your portfolio. Asset allocation is complex and critical to the investment process; however, the concept is quite simple.
Most of us, as investors, have practiced diversification tools such as "don't put all your eggs in one basket." Asset allocation, however, takes diversification one step further by "don't use all the same kind of baskets."
One of the most critical decisions when building your portfolio should be to diversify by investing in several different asset classes such as growth, value, small cap, and international stocks, bonds of various maturities or specialty areas, and short-term or cash equivalent investments. Dividing your holdings among various asset classes can reduce your portfolio's exposure to any single investment area. This tends to lower your total risk while still seeking, for example, a growth objective in your portfolio.
Many studies show that asset allocation plays a stronger role in helping to construct successful portfolios for long-term performance than market timing or the selection of individual securities. Spreading assets across stocks, bonds and short-term instruments can have a greater effect on portfolio performance, and relative risk/reward success, than predicting the success of specific securities.
The balance chosen between fixed income and equity is a major decision in constructing your portfolio. This decision has little, if nothing, to do with your age, an opinion that differs from textbook definition; instead, it relates to current economics, falling or rising interest rates and the general market.
If the fixed and equity balance is not right, your portfolio construction process may not work properly. For instance, as a long-term investor, you choose to invest 90 percent in short-term bonds. No matter how well the other 10 percent is managed, your portfolio will likely be reduced with inflation over time.
There are several other risks that can influence your returns. Market risk is one way your investment can lose value. Most large company domestic stocks may work similarly to an index of large domestic stocks; but as in the international markets, the results of active management can differ greatly.
Inflation and interest rate risk also must be considered and oftentimes move together.
As interest rates climb, cost of goods and inflation rise, eroding the value of rate-sensitive investments, for example, long-term bonds. The asset class of short-term investments (such as cash or Federal Deposit Insurance Corp. insured bank money market accounts) may have a potential to increase in value when interest rates rise.
Falling interest rates could, however, increase the market value of stocks whose return may prove higher than short-term assets, making them more attractive.
Diversifying among several asset classes increases the possibility that while one class decreases in value, another class may increase. Beyond the basic mix of stocks, bonds, and cash, choosing sub-asset classes can further reduce the several risks that can influence your portfolio.
Kim Ciccarelli Kantor is president and founder of Ciccarelli Advisory Services Inc., a family owned and operated firm in Florida and New York, which provides comprehensive financial investment and estate planning services for individuals, families and businesses.
Ciccarelli Advisory Services, Inc. is at 3066 U.S. 41 N., Suite 202. For more information, call 239-262-6577 or visit casmoneymatters.com.