In my previous commentary, I discussed the concept of diversification and the need to add small-cap stocks in an effort to increase the expected return of your portfolio.
I would like to discuss the concept of asset allocation as a critical part of any prudent portfolio management strategy.
Asset allocation refers to the asset mix of your portfolio, which is divided into the three major asset classes: cash; fixed income; and equities (stocks).
As the macro and micro factors change, as well as your investment objectives, you should rebalance your asset mix accordingly taking into account the new conditions.
In general, without going into portfolio theory, the risk and expected return of an investment increases as you move along the spectrum from cash to fixed income to equities. The more risk assumed, the higher the expected rate of return, albeit this is not always the case in reality.
The relationship between risk and return should be used as a guideline.
The proportion of each asset class within your portfolio is dependent on your individual risk profile. For instance, the more risk-adverse investors or those who are close to retirement may want a higher mix of fixed income/cash and to steer clear of too much equity. On the other hand, risk-tolerant investors or those investors who are young may want to take a more aggressive approach and maintain a higher mix of equities in conjunction with less fixed income/cash.
A general rule for asset allocation is that the weighting of the fixed income portion as a percentage of your total portfolio should approximate your age.
Let’s say you are 25 years old. The basic guideline tells us you should have about 25% of your assets in fixed income and up to 75% in equities. And on the other end of the spectrum, a 50-year-old entering the final phase of his or her working life should have a conservative 50% weighting in fixed-income securities. And, of course, a person at the retirement age of 65 should have a minimum of 65% in fixed income.
Keep in mind that this rule should only be used as a guideline and is not meant to be conclusive.
Prudent asset allocation tries to achieve the highest rate of return given the risk. The most basic part of investing is understanding how to create an appropriate blend of equity, fixed income, and cash.
To determine your risk profile, you should first understand your investment personality.
Investors range from the ultra-conservative investor who wants to sleep at night to the highly aggressive speculator who thinks of the stock market as a roll of the dice. It is crucial that you stay within your risk boundaries if you are very conservative. For example, if you tend to get jittery when the stock market gyrates, you may want to focus more on fixed incomes and less on stocks; otherwise, you’ll be reaching for that bottle of “Prozac” a bit too often.
Asset allocation is often dependent on your age, but, in reality, understanding each person’s risk profile is also very important. The only rule that generally applies is that the older you get, the less exposure to equities you should have, as you don’t want to risk your life savings for a hot tip.
Among market watchers, there’s an old saying: “Bulls make money, Bears make money, Pigs get slaughtered!” Translation: Don’t get too greedy, and live within your risk profile.