Asset Allocation

Asset allocation is the key ingredient in a successful investment strategy. In simplest terms, asset allocation is the process of deciding which broad categories of investments to invest in, and then dividing up the money in your portfolio among them. These broad categories are called asset classes (more on these later).

Advantages of Asset Allocation

* It's investing -- not speculating. The goal is consistent long-term performance rather than spectacular or disastrous short-term results.
* It's a proven long-term diversification strategy that balances risk and return.
* It takes the guesswork and emotions out of portfolio management.
* It focuses on the portfolio as a whole.
* It's the best way to create a portfolio that will stay in line with your investment objectives.
* It's easy to implement, monitor, and rebalance.


Determining Your Asset Mix

* Risk Tolerance -- how much fluctuation can you accept.
* Any anticipated lump-sum or ongoing income needs -- for example, college tuition or a second home.
* Current amount of investable assets.
* Age and life expectancies of everyone expected to benefit from your portfolio.
* Income from any other sources.


Asset Classes

In general, I recommend that individuals consider the 12 asset classes identified in Your Nest Egg Game Plan (derived from the 7Twelve Portfolio developed by my co-author, Prof. Craig Israelsen of BYU).

* Cash
* Short-Term Bonds
* Intermediate-Term Bonds
* High-Yield Bonds
* International Bonds
* U.S. Large-Cap Stocks
* U.S. Mid-Cap Stocks
* U.S. Small-Cap Stocks
* International Stocks
* Emerging Market Stocks
* Real Estate
* Commodities and Natural Resources


Not all asset classes need be used by all individuals, and the weighting of each asset class will vary greatly depending on your investment temperament, risk tolerance, and time horizon.

 

The Asset Allocation Investment Pie

Think about asset allocation as the process of making an investment pie. When you make a pie, you use different mixes of basic ingredients. Sometimes you use white flour and sometimes wheat. Sometimes you use fruit filling and sometimes custard. It's the same thing when making an investment portfolio -- you build the model based on what you want the end result to look like. Here's an overly simplified example that illustrates the point.