Have you heard the term asset allocation but arent quite sure what it really means?

We believe strongly that asset allocation is a key element in successful investing. Asset

allocation involves the decision as to what percentage of your portfolio to invest in each

of several different classes of assets.

To understand what were really talking about, lets first define what we mean by an

asset class. An asset class is a broad grouping of investments that share common

characteristics. Examples of asset classes are cash, short-term bonds, international

bonds, large company domestic stocks, international stocks and real estate stocks.

A famous study of 91 major pension funds was conducted a number years ago to

determine what factors had an impact on the funds success. The study postulated that

plan performance was linked to three factors: security selection, market timing and asset

allocation. The study found that asset allocation was the key factor in a plans success.

While security selection is worth considering, it isnt as important as one might think.

And, market timing is a futile thing to try to do. You have to know exactly when to buy

and when to sell, and determining the correct time for even one of those events is

extremely difficult to do.

There are two very broad types of asset classes: stocks (equities) and bonds (fixed

income investments). The first decision you have to make is how much to invest in

stocks and how much in bonds. There are various ways to do this, with many

investment advisors using questionnaires to determine their clients risk tolerance. You

often hear advisors on the radio and TV ask callers if they are conservative, moderate

or aggressive investors. They then give advice based on the callers response. The

problem with this approach is that what is aggressive or moderate to one person may

be quite different to another investor.

We use an approach developed by Roger Gibson, author, speaker and investment

advisor to wealthy clients in Pennsylvania. Mr. Gibson wrote a book called Asset

Once the basic equity/fixed income allocation is determined, you then need to allocate

the equities across several stock asset classes. We use large domestic, small domestic,

international and real estate investment stock asset classes. For fixed income we use

cash or cash equivalents (money market, short-term CDs, etc.), short-term bonds,

intermediate-term bonds, high-yield bonds and international bonds. All investments are

made via low-cost, no load mutual funds, index funds and exchange-traded funds (called

ETFs).

When you choose funds you need to pay careful attention to the funds expenses and

tax efficiency. It makes sense to place income-producing assets in retirement accounts

(since they are currently not taxable) and growth assets in non-retirement accounts

(since they typically generate little current income). Fees and taxes can reduce your

return substantially. Having a portfolio of broadly diversified mutual funds lowers

portfolio risk and can actually increase returns. Companies like Fidelity, Schwab,

Vanguard and others, provide the ability to buy a large selection of mutual funds, often

with no transaction fees.

Once you achieve your target portfolio, it makes sense to rebalance at least annually.

This involves selling some of your over-allocated asset classes and buying the under-

allocated asset classes (i.e. selling your winners and buying more of the losers).

Asset classes go through up and down cycles. When they are down, its time to buy

some more, and when theyre up, its time to sell. This is contrary to what investors

typically do. Most investors want to buy the hot asset classes (buy when high) and

panic when the market takes a severe downturn and sell the depressed assets (sell

when low). They need to do just the opposite. If you rebalance at regular intervals, you

will not be timing the market but rather youll be using a disciplined approach to adjust

your portfolio. Over time youll do much better than investors who buy and sell based

on their undisciplined emotions.

It is important to monitor your portfolio as a whole and not focus on any one account.

Some accounts may contain only asset classes that are in their down cycle. Its tempting

then, to think those investments should be sold. If you hold good mutual funds, you will

want to buy more in those instances, rather than sell. This is where discipline is needed

to stick to the correct strategy.

Asset allocation provides a disciplined investment approach that will help maximize your

investment returns and and allow you to sleep better at night! Weve used this same

approach for our personal portfolios for over ten years (through good and bad

markets). It works!

David C. Patterson, CFP and Erin Patterson, CFP are the owners of Patterson Advisors, LLC, a fee-

for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,

registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan

as well as other Oakland County, Michigan communities. Visit www.pattersonadvisorsllc.com for more

information or call 248-674-2108.

Published in the Oakland Insider. November, 2007