The financial markets can be volatile. Tohelp weather the storms, diversification iskey. But you shouldn't stop there.Asset allocation takes the process a step further bydiversifying your investments among different assetclasses, such as stocks, bonds, cash equivalents, realestate, and other tangible assets. Bothasset allocation and diversificationshould be utilized in determining yourinvestment mix. Having a plan in placeand keeping it on track with periodicrebalancing can give you peace of mindand help you achieve long-term goals.
KEY OF UNDERSTANDING
Asset allocation is based on somebasic principles of investing. The first isthat historical evidence shows that notall classes of assets move up and downat the same time. While one year largecompany stocks may generate the highestreturns, the next year corporatebonds could outperform. History alsotells us that some asset classes are morevolatile than others. One asset class mayexperience big gains one year followedby huge losses the next, while anothermay provide steady returns.
Though academic opinions vary onthe degree of its importance, some studiesindicate that asset allocation can accountfor over 90% of investment returns. Additionally,owning a mix of assets can help controlrisk and increase predictability of returns.
So how do you know which asset allocation isright for you? Base your decision on 5 factors:financial goals, investment time horizon, financialsituation, expertise, and tolerance for risk. Howyou combine asset classes can have a considerableimpact on the risk/reward profile of your portfolio.
The more risk you are willing toaccept, the greater potential for reward.Investments that offer higher returnpotential are generally more volatile overshorter periods, but this volatility has historicallysmoothed out over time. Thelonger your investment horizon, themore risk you may be willing to take.
Of all the major asset classes, stockscarry the most risk to your original investment,because the value of a stockmay fluctuate sharply over short timeperiods. But, according to IbottsonAssociates, since 1925, stocks have notonly grown in value, but they have outperformedother investments, such ascorporate and government bonds andTreasury bills.
However, though bonds have historicallyproduced lower returns than stocksover the long haul, the potential for regularincome and relative stability mayoffset some volatility of a total stock portfolio.So including a percentage of bondsin your portfolio may also help youweather market fluctuations. For years, bonds'potential for steady income has provided investorsa cushion against downturns in the stock market.
YEARLY REBALANCING ACT
Once you've determined the right mix of assetsto suit your financial profile, you will need to periodicallyrebalance your portfolio. Rebalancingmeans adjusting your investments to match yourtarget mix. For many investors this is a tough disciplineto implement, because it runs contrary tointuition. It means selling shares from your bestperforming assets and turning around and buyingshares in your worst performing asset class.
The primary purpose of rebalancing is to managerisks, not maximize returns. Because stockshave historically outperformed bonds, if you do notperiodically rebalance your portfolio, stocks maytake on a disproportionate piece of your investments.Of course, in both these instances, past performancedoes not guarantee future results.
How often you should rebalance your portfoliodepends on the size and tax sensitivity of your portfolio.Rebalancing once a year is probably adequatefor most people. You will also want to take intoaccount the tax consequences of rebalancing andmay want to direct your transactions into your nontaxableaccounts, such as IRAs or 401(k) plans. Taxconsequences alone, however, should not driveyour rebalancing decisions. Discuss all tax-relateddecisions with your tax advisor.
So if today's volatile markets leave you wonderingwhere to invest, start by developing an asset-allocationstrategy that can help mitigate risk andsmooth out some of the ups and downs you mayexperience. A qualified advisor can evaluate yourgoals, time horizon, and risk tolerance and determinea plan that is right for your situation.
Louis M. Bell, financial advisor, and Marc S. Levitt,
financial advisor, are a team at Prudential Securities specializing in financial advisory and investment management
services for individuals, medical practices, foundations, and trusts. They welcome questions or comments
at 212-303-8724, firstname.lastname@example.org, or email@example.com. E-mail cannot be used for trade instructions
or anything requiring your signature. Past performance is no guarantee of future results.