Tuesday, August 21st, 2012

by Al Zdenek

You know you are supposed to diversify so that you do not have all of your eggs in one basket. Yet not everyone practices this investment rule. At our wealth management firm, we often see new client investment portfolios that are unintentionally risky due to asset allocation errors.

For instance, one investor we met held shares in several large-cap, value-oriented U.S. stock funds thinking that if investing in one such fund was good, then investing in a handful of them must be better. This may sound like a logical move. However, buying more of the same only increased this persons risk exposure to the price movement of large-cap value stocks

The starting point for a well constructed investment strategy is not deciding which particular stock, bond or fund you should buy. Instead, your major decision should be how to construct an asset allocation. This is the key to generating return while dampening portfolio volatility

Research 1 has documented that the asset allocation mix of a portfolio accounts for over 90 percent of the return variations (volatility) that an investor will experience. Securities selection and market timing account for under 10 percent of the volatility investors experience.

Historically, over the long term, stock and bond prices do not move in lock step with each other. Likewise, the performance of asset classes such as real estate, commodities, private equity investments and hedge fund strategies tend not to mimic the performance of the S&P 500 Index.

The more the asset values of your investment holdings rise and fall in synchronicity, like those of the investor described above, the greater your risk. Consequently, if you construct a portfolio that gives you exposure to a variety of asset classes, investment styles, capitalizations and geographic locales, then over the long term you will reduce how much risk (in the form of volatility) your portfolio exposes you to.

SETTING YOUR MIX

What specific holdings should be in your asset allocation mix and at what percentage weighting?

There is no cookie cutter answer regarding what asset allocation is right for you. Sit down with a wealth manager for help in assessing where you stand today and how much wealth you need to accumulate in order to achieve and maintain your wealth goals. Importantly, assess how you can preserve your wealth once you decide to stop working. With that information, plus an evaluation of your current investment portfolio, educated decisions can be made about improvements to your asset allocation.

When my wealth management firm runs an analysis to determine what asset allocation best meets a particular client?s risk/return needs, we consider more than just the broad categories of stocks, bonds and cash; and so should you. Look deeper into segments of the equities, fixed income and alternatives markets, and you will find more sub-classes. You need exposure there as well.

Above all, do not attempt to guess which asset class will be the top performer this year or next and only invest there. That is a loser?s game. Diversify and let the asset allocation policy statement that you develop with your wealth manager be your guide.

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