Many investors spend the preponderance of their time on selecting securities and very little on asset allocation, just the opposite of what they should be doing.
Studies show that asset mix accounts for more than 90% of investment results, with individual security selection and other factors responsible for less than 10%. Yet most individual investors do not use asset allocation to their advantage. They spend the preponderance of their time on selecting securities and very little on asset allocation, just the opposite of what they should be doing.
Many people that do pay attention to asset allocation believe that mixing stocks and bonds creates a well-diversified portfolio. But it does not — you need to add the right amount of other assets, such as commodities, to unlock the power of asset allocation. You want the right mix of assets that typically do not move in sync with each other.
One of the keys to making this all work is rebalancing, which demands that you systematically sell some of your winners and buy more of your losers. That’s hard to do, but you have to be unemotional and disciplined to be a successful investor.
Here are four steps to optimal asset allocation:
1. Decide on your investment strategy.
How conservative or aggressive should you be? Determine that carefully and then write your strategy down.
2. Figure out your asset allocation.
Decide on the asset classes and subclasses you want to use. They include cash, bonds, stocks, and alternatives like real estate and commodities. Then determine how big each asset “basket” should be to implement the investment strategy you decided upon.
3. Fill your asset baskets with the right specific investments.
Put tax-inefficient assets like real estate investment trusts (REITS) in tax-deferred accounts and put tax-efficient assets like growth stocks in taxable accounts.
4. Rebalance opportunistically.
When some of your asset baskets start to overflow, redistribute the excess to the ones that are under-filled. By systematically selling high and buying low, you’ll not only keep your allocation on track, but —in the closest thing to a free lunch you’ll ever find in investing — reap higher returns with less risk over the long haul.
Jerry A. Miccolis, CFA®, CFP®, is a senior financial advisor and co-owner of Brinton Eaton Wealth Advisors, a fee-only investment management, tax advisory and financial planning firm in Madison, N.J. He is the coauthor of the new book, Asset Allocation For Dummies® and can be reached at Miccolis@brintoneaton.com.