Asset allocation is an investing strategy for maximizing your returns while minimizing the overall risk level of your investment portfolio. It involves diversifying your assets among different broad categories of investments, such as equity, fixed income, and money market, etc.  By reducing your investment risks, youre in a better position to meet your financial goals.

How Asset Allocation Works

The underlying mechanic that makes asset allocation a powerful tool for any investor, is the idea that best-performing asset varies from year to year (i.e. asset correlation) and is not easily predictable .  For instance, your stock investments may do well for several years, but you will eventually run into a slow market or a Bear Market where other assets will outperform stocks.

This difference causes your allocation percentage to diverge from the original target over time, because better performing assets will grow larger as underperforming assets grow smaller relative to each other.  Once the allocation no longer aligns with the original target, the investor then rebalance the portfolio to restore the original percentage.  This involves selling some of the better performing assets to buy some of the underperforming assets.  This is buy low, sell high at its best.

Four Asset Allocation Methods

When I work on my portfolio asset allocation, there are four different types of allocation that I consider to be the most important.

1. Traditional Asset Allocation

The traditional method of asset allocation breaks down your investment into four broad categories:

• Domestic Large-Cap Stocks
• Domestic Small-Cap Stocks
• Bond
• Foreign Stocks

The allocation is usually represented as a pie chart, which is further classified as aggressive, moderate, or conservative based on investors risk tolerance level and time horizon .

• Aggressive This type of portfolio is appropriate for investors with high risk-tolerance and/or long investment time horizon.  This portfolio has a higher percentage of stocks relative to bonds.
• Moderate This type of portfolio is appropriate for investors with medium risk-tolerance and/or medium investment time horizon.  This portfolio has a lower percentage of stocks relative to bonds.
• Conservative This type of portfolio is appropriate for investors with low risk tolerance and/or short investment time horizon.  This portfolio has the lowest percentage of stocks relative to bonds

Your goal is to choose the right balance between stocks and bonds based on your risk tolerance level and investment time horizon. You can try the CNN Asset Allocator to see what a recommended portfolio looks like.

2. Morningstar Style Box Diversification

Another way to view asset allocation is based on the Morningstar Style Box. which divides your investment according to nine categories according to the market capitalization and valuation.

Since the traditional asset allocation accounts for market capitalization, the real value of this method is the value versus growth comparison.

• Growth stocks are shares in a company whose earnings are expected to grow at an above-average rate relative to the market. The company is growing earnings and/or revenue faster than its industry or the overall market.
• Value stocks are shares in a company that tends to trade at a lower price relative to its fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

Its important that you do not mistaken growth for higher return on investment .  Based on the Efficient Market Hypothesis. the market already taken the higher growth rate into account and it is already reflected in the price.  A value stock could very well turnaround, become favorable, and outperform a growth stock. Just like before, its not possible to predict if value stocks will outperform growth stocks for any given year. Theres a good article called, Value Versus Growth Monthly Returns that illustrate this concept and explains the image below:

Your goal is to diversify and balance growth versus value so that you are not over invested in one area or another.

3. Stock Sectors Diversification

The next method deals with sector (or industry) that your investments belong to. The top five sectors based on the S&P 500 are: Energy (16%), Financial Services (14%), Industrial Materials (13%), Healthcare (12%), and Technology Hardware (10%).

Your goal is to spread your investments across many sectors, so that you are not over invested in any one sector. This is how you protect your portfolio against catastrophic events, such as the collapse of Dot-com Bubble of early 2000s and Subprime Mortgage Crisis of 2007/2008.

4. World Regions Asset Allocation

The last type of asset allocation deals with the geographical region of your investments. The top geographical markets includes:

• North America
• UK and Western Europe
• Japan
• Latin America
• Asia

In my article How Much Should We Invest Internationally? . I argued that the traditional view of limiting foreign investments below 20% of your total assets is too conservative and we should be aiming for 30-50% mark.  Larry Swedroe concurred with this assessment in the April 2008 issue of the Ask The Expert article:

I believe investors should consider having 50 percent of their equities in international stocks and have at least 30 percent.

Your goal is to spread your investments across geopolitical boundaries and position your portfolio to capture the growth potential of developing markets, while balancing it with the relative security of matured markets.

How to Determine Your Ideal Asset Allocation

Figuring out your ideal asset allocation is a very personal thing, and there is no right answer. When determining your asset allocation, the two most important factors are your risk tolerance level and your investment time horizon.

• Risk tolerance level is your willingness to bear the risk of potentially losing some or all of your money in exchange for higher potential returns. For example, an aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. Its important to be truthful to yourself when considering your risk tolerance level because the last thing you want to do is prematurely sell your investments in a panic.
• Investment time horizon is the expected number of months or years you will be investing to achieve a particular financial goal. For example, if you are investing for retirement that is 35 years away, you could afford to take more risk because you can ride out the down periods.  On the other hand, you want less risk if you are a retiree or if you are saving for a short-term goal.

Balancing Risk and Reward

One way to help you determine your ideal asset allocation is to first look at how much you need to have and how soon. Also, you need to determine if you could afford to wait a few more years if you dont achieve your goal within the target deadline.

For example, lets assume you need to save $100,000 for a down payment in 5 years, and can afford to save $1,200 a month for the next 60 months.  If you calculate these numbers, your investments must have a combined average annual return of 12% per year.  This requires an aggressive portfolio, but 5 years is a short time and you could lose some or all of your money.

Your possible alternatives are:

• Extend your time horizon. For example, you can save $100,000 by adding $1,200 per month to an  investment portfolio that has a combined average annual return of 5% in 6 years.
• Increase your monthly contribution. For example, you save $100,000 by adding $1,500 per month to an  investment portfolio that has a combined average annual return of 5% in 5 years.

Now that you understand what portfolio rate of return need to be at, you could more realistically decide your asset allocation.  For example, if you are shooting for a 5% rate of return, you could construct a conservative portfolio.  However, if you are shooting for a 12% rate of return, you will have to be more aggressive.

Other Factors Affecting Your Asset Allocation

Aside from the three main concepts above, there are other factors that you need to consider in your asset allocation strategy.

Investment Type And Performance

Although asset allocation supposed to make performance of individual investments less important, it is still a factor.   When choosing stocks, you should perform your due diligence and understand the underlying fundamentals.  A more effective way of construct a diversified portfolio is through the use of mutual funds and ETFs; preferably passively managed ones because the underlying assets are more predictable and their lower expenses.

Moreover, traditional asset allocation model only mentions stocks and bonds.  But you are not limited to just these assets.  There are many types of investment that you can use to build your portfolio e.g. high yield savings, CDs, money markets, whole life insurance, bonds, treasury securities, REITs, futures, options, etc.

Expenses

When you are building a portfolio, its possible that you will be carrying out several transactions per year i.e. adding new fund and rebalancing your portfolio.  As such, its important to choose the right investment vehicles to keep your expenses as low as possible, because the impact of high expenses could be significant .

• Stocks Aside from Berkshire Hathaway. it would be difficult and not very cost effective to build a diversified portfolio with individual stocks
• ETFs If you are investing large amount of money, ETFs may be better than mutual funds because of their lower expense ratios.
• Mutual Funds Mutual funds may be the best option for building a diversified portfolio, especially if you stay with no load no fee mutual funds with low expense ratios.  This type of funds allow you to purchase new shares in small increment at no cost and you could sell them after a period of time without paying any fee.

Asset Correlation

Another term you should understand is asset correlation .  The power of asset allocation depends on having a combination of investments that have low correlation .  This means that if a group of your investment is doing well, another group wont but this means your entire portfolio wont tank at the same time and youll be able to rebalance to buy low, sell high .

Lets take a look at the table above.  You can see that Large Stocks has a correlation coefficient of -0.02 compare to Treasury Bills.  This means that when Large Stocks go up in value, Treasury Bills go down.  On the other hand, Large Stocks and Small Stocks with a correlation coefficient of 0.79 will track each other well but not perfectly.

In other word, you can think of Bonds and Treasury Bills as insurance policy against declining stock market condition for your stock investments.

Portfolio Rebalancing

This is where the magic happens with asset allocation.  When your allocation shifted from its original percentage, you are selling some of the assets that have been doing well and use that proceed to buy more shares of assets that have been underperforming to restore the original percentages.  This is basically a buy low, sell high technique.

However, you dont want to rebalance your portfolio too often because youll have to deal with transactional expenses and taxes.  Its recommended that you rebalance your portfolio at least once a year and no more than once a quarter.  Instead of rebalancing based on time period, a better strategy is to rebalance when the portfolio is a few percentages different from the original allocation.

A strategy that you can use to reduce trading costs and tax consequences is to slowly adjust your portfolio using new funds to buy more of the underperforming assets. This should bring things back into the proper allocation for a smaller portfolio.  This technique may not be adequate for a larger portfolio.

Portfolio Realignment

Depending on your goal, you could have a portfolio that will last for several decades.  As you grow older, your risk tolerance level and investment time horizon will change.  Every few years, you should carefully reconsider your asset allocation against your financial goal to make sure they are still in agreement.  Often, youll find that investors shift toward a more conservative portfolio as they grow older.

Tax consequences

Another factor is the tax consequences of your investment activities.  How you manage your portfolio, the types of investment, and the nature of the account (i.e. taxable versus tax-sheltered) could have an impact on your investment performance.

Some strategies to consider with regard to taxes include:

• Tax loss harvesting your taxable account
• Put bonds and high-dividend yielding investments in tax-sheltered account
• Minimize buy/sell to reduce capital gains tax liabilities

Target Retirement funds

If all these asset allocation ideas are giving you a headache, you may be a good candidate for target retirement fund .  With target retirement fund, all you have to do is pick the one that has a target date closest to your financial goal

A Free Tool to Help Allocate Your Investments

You can use Personal Capital to link to your investment accounts and use their Investment Checkup feature to analyze your asset allocation. It will provide you with valuable information, such as, recommends your target allocation, shows where you are overweight and/or underweight, allows you to drill down and see how each investment is contributing toward different asset classes. Here’s is a screen shot of what it looks like: