10 Tips for Asset Allocation

One of the biggest investment decisions an investor will ever make is his or her asset allocation. Aside from the performance of the stock market and the economy in general, there is no greater influence on investment returns than asset allocation. Luckily, it is a factor over which we have complete control. Because asset allocation determines how much risk a portfolio carries, is a very personal decision. However, here are 10 things to consider that can help guide any investor through the process of developing his or her ideal asset allocation.

Risk

The first thing an investor should ask him/herself is "How much risk can I handle?" The stock market is very volatile, and some people can't stomach the ups and downs. Bonds and other fixed income investments are much more stable than stocks, but they tend to have lower returns over the long haul. Each investor must decide how much of his or her portfolio to allocate to stocks and how much to fixed income. There are tools such as risk calculators available on the web, which can help you determine your risk tolerance.

Age

When determining risk tolerance, an investor must also think of his or her age. Younger investors have more time to ride out the bumps of the stock market and can therefore be more aggressive, but some young people are naturally risk averse. Similarly, older investors may be daredevils by nature, but their age may require them to be more conservative. However, older investors need portfolio growth too. Retirement age is 65, but people are now living to 85, 95 and even longer. Retirement-age investors need an asset allocation that will keep them solvent for another 30+ years. You will want to revise your asset allocation every so often, as you age and your goals change.

Which Accounts to Consider?

All of them! Actually, there are many different opinions on this, but the best way to get a comprehensive look at your asset allocation is to look at all of your accounts, including your checking and savings accounts (if they make up a large enough percentage of your overall total to matter). In my case, I have all of my retirement money invested in the stock market, but I have a non-retirement savings account that makes up about 10% of my total holdings, which I look at as my "fixed income" allocation.

Home Equity?

Some investors look at home equity as part of their asset allocation, but if you have a lot of equity in your home it may throw your overall picture out of whack. Also, home equity is meaningless until you sell your home, and there's no guarantee that you're going to be able to sell it for what you think it is worth. Personally, I keep my estimated home equity in mind when making investments, but I don't include it in my overall asset allocation.

CDs, Stocks, Bonds or Mutual Funds?

CDs are a good investment for extremely conservative investors - most CDs earn only a little more interest than a savings account, but they carry virtually no risk. However, for most investors, mutual funds are the way to go. Individual stocks and bonds carry a great deal of risk with little or no reward upside, and unless your portfolio is absolutely huge, there's no way that you'll be able to buy enough individual stocks and bonds to cover all of your bases. Mutual funds are not risk-free, but their inherent diversification makes them less risky than single stocks. There are thousands of stock and bond mutual funds out there, so you will have no trouble finding enough to meet your asset allocation needs.

Diversification

The last thing any investor should do is put all of his or her eggs in one basket. However, this doesn't mean that you should own 100 different mutual funds, either. Since a mutual fund is made up of small slivers of many stocks, you should be able to get complete diversification with just a handful of mutual funds. Some investment advisers advocate owning as few as two mutual funds - one that contains the entire stock market, one that contains the entire bond market. Many fund companies now offer Target Date Retirement funds as well, which are one-stop funds for investors who want complete diversification and risk management, but don't want to have to think about it, ever. Asset allocation doesn't get any easier than that.

Growth vs. Value

If you're willing to own more than just two funds, you can further customize your asset allocation by choosing growth or value funds. Growth stocks are from more established companies with a history of higher earnings, and tend to be less risky than value stocks, which are from companies that may be new or unstable for some reason. Value stocks carry greater risk, but come with the possibility of greater rewards. You can tilt your asset allocation toward value or growth, depending on your risk tolerance.

Large Cap vs. Small Cap

There are companies of all sizes in the stock market, and a savvy investor can personalize his or her risk to reward ratio by choosing to tilt his or her asset allocation toward larger or smaller companies. Smaller companies tend to be a little riskier than larger ones, but they can also pay off big in the longer term. Of course, if you have a mutual fund that covers the entire market, then you automatically own both.

REITs

REITs (or Real Estate Investment Trusts) are basically corporations that invest in real estate in a tax-advantaged manner. They pass their profits along to their shareholders in the form of dividends. Most investment professionals consider them stocks, and would count them in the equity portion of an investor's asset allocation. They are a great way to add diversity to your asset allocation, but like any stock, they add risk as well.

International or Domestic?

The world economy is growing, and investors want a piece of the action. International stocks are a great way to get it. However, some investors may be more comfortable investing solely in American companies, and that's fine too. International stocks offer diversification and the possibility of great returns, but they also come with risk.

There are many more things to consider when developing your asset allocation, but this list gives you a good place to start. For further information, I highly recommend a wonderful website called FundAdvice.com, which has many in-depth articles on all sorts of financial topics.