Many studies have indicated that asset allocation is the single most
important strategy an investor can use to build wealth.
Asset Allocation Maximizes Diversity. Without asset allocation
you maximize your risk. If you place all your investments in one mutual fund,
or one major market, or one investment class or sector, your portfolio will
lack investment diversity—defaulting to the one-egg in one-basket investment
style. In any discipline, it almost always is the case that when there is
no plan, one indirectly plans to fail sooner or later. You never want to be
too focused by investing only in one area just in case it suffers a great
loss due to a devaluation of the market directly affecting those holdings.
When you look at the capital needed for retirement (see the graph), it is
apparent that we need to minimize our market risks.
What is asset allocation in a nutshell? In a better light,
asset allocation means establishing a defined ratio of stocks, bonds and cash
in a portfolio. The right asset mix in relation to an investor’s age
and his or her profiled risk tolerance can create higher returns, while governing
risk. So the key is to divide your investments among different kinds of assets:
stocks; income securities; real estate; and cash (such as money market funds);
and different markets—including foreign markets among their various
sectors—in order to design the most advantageous counterbalance of risk
versus reward.
Assumptions: The figures
in the graph approximate the capital needed at the outset of retirement, to
generate income for 20 years while in retirement (e.g. from age 65-85) at
the indicated yield, held in an RRSP; stated as net-of-tax income at the rate
of 20% taxation; with the income increasing annually at 2.5% inflation.
Spreading out your risk. When you own mutual funds, you
own securities from many different companies. To diversify, you could own
different funds that each focus on the companies of different industries (within
any given market). Similarly diversify among funds focusing on rapid growth
and others with a mandate to invest with a buy and hold philosophy such as
blue-chip companies—the old die-hards that just keep delivering profits
slowly over the long haul. The idea is to smooth out volatility—ideally
to limit any negative effect on your assets invested in any one place. Ultimately,
you should consider your investments in terms of your tolerance for volatility.
Endless variations are possible. Any possible variation
of assets can be set up in a targeted asset allocation solution. The most
important consideration is that the assets do not correlate too closely among
other assets within one market.
Getting professional investment help. Some advisors can
create sophisticated models of diversification based on your profile which
is a combination of: your age, time left before you need to use your capital,
how much you’ve already saved, and your stomach for risk. Other advisors
utilize asset allocation systems already developed by mutual fund companies.
This would be designed allocation among a family of funds usually offered
by one company—thus professionally managed to achieve the necessary
diversity and ratios that meet your own goals. A fund company easily manages
transferring among a family of funds to maintain these balances internally,
and can factor in all market trends that might affect your investment.
Asset allocation is the method of creating investor diversification.
Because certain asset classes react differently to economic conditions, this
means that most likely some portion of your portfolio will perform well at
the same time another is not. The right combination of funds among equities,
income assets (bonds, trusts, etc.), and cash can help reduce your portfolio’s
volatility.
The key is staying balanced in the same asset allocation ratios.
This is referred to as “rebalancing” to maintain your initial
apportioned diversity. Once you have established your allocation goals, review
your predetermined ratios over specific time periods such as annually. Among
your investments—for example, among growth equity funds, large-cap funds,
small-cap funds, foreign equity funds, and bond funds. Reset the same percentages
of these various holdings in your portfolio.
Why is rebalancing necessary? First, you establish your
unique percentile holding in each asset category. Because these sectors will
perform differently between reviews, you’ll need to rebalance these
investments periodically to restore the desired ratios. In time, the assets
that will gain more profit, will account for the increasing percentage of
your holdings, while others will decrease. Some asset allocation systems,
such as offered by certain fund companies, will automatically rebalance the
ratios to the original allocated percentages.
Ways to rebalance.
• Buy low, sell high. Rebalancing (much like dollar
cost averaging), takes advantage of buying more of the lower priced units
in your portfolio and holding less of the higher priced units. Rebalancing
involves re-establishing ratios by selling the highest yielding units to buy
more of the lower value units. This is easily done among a family of funds
designed for asset allocation and rebalancing.
• Dollar cost averaging. Invest future purchases in
asset classes whose unit values have not increased, thus buying more units
at lesser prices.
• Increase contributions. Add more money to purchase
more of the underperforming asset class until it is rebalanced to the correct
target mix of the overall holdings.
