One of the best ways to maximize the long-term performance of your investment portfolio is through proper asset allocation. The term asset allocation refers to how you divide your investments among the three key asset classes -- stocks, bonds and cash-equivalents. In other words, it means not putting all your eggs in one basket.
According to the Minnesota Society of CPAs, research has shown that 90 percent of overall portfolio performance is determined by asset allocation -- and not by the actual investments you select or your ability to time the market. Thus, asset allocation is essential to building your financial future.
Why asset allocation is important
Asset allocation works because each of the three key asset classes tends to react differently to economic events and market conditions. In some years, stocks fare better than bonds. In other years, bonds may outperform stocks. Determining which asset class will do best in a given year is difficult -- even for professional investors. But by dividing your assets among the three major asset classes, you spread out both your opportunities and your investment risk.
Let your needs drive the process
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The proper asset allocation for you depends on a number of factors including your age, financial goals, risk tolerance, time frame and overall financial situation. Taking these factors into consideration helps to ensure that your asset allocation strategy is appropriate for you -- neither too aggressive nor too conservative.
Generally, younger investors can allocate more of their investments to stocks, because they have more time to weather short-term drops in the market. Investors with a longer investment time horizon should consider investing80 percent of his or her assets in stocks and 10 percent each in bonds and cash.
On the other hand, if you plan to retire in a few years, are likely to need your money in the short-term or have a very low tolerance for risk, you might take a more conservative approach. For example, you could invest40 percent of your portfolio in stocks, 40 percent in bonds, and 20 percent in cash. Since some growth is important in all portfolios, CPAs generally advise that even conservative investors and those in retirement keep some percentage of their assets in stocks.
Diversify within asset categories
After you allocate your investments over the three broad asset classes, you need to go a step further and diversify the investments within each asset class. For example, your stock portfolio should include investments in several different industries and sectors, such as technology, health care, financial services and consumer products. It's also a good idea to include both domestic and international investments, since different economies may experience ups and downs at different times.
Rebalance regularly
The beginning of the new year is an opportune time to review your asset allocation. Revisit your investments and goals regularly to determine whether your asset allocation still makes sense. For example, as you move closer to retirement, you may want to begin to gradually move some -- but not all -- of your assets out of stocks and stock funds.
Over time and as a result of performance, the value of the various assets within your portfolio will change. For example, if your stocks do particularly well one year, your portfolio may turn out to be more heavily weighed toward equities than you originally intended. To rebalance, you may want to sell some stock and reinvest the money in bonds or cash. Or if you have additional money to invest, you can invest those dollars in bond or cash funds.
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Money Management is a series provided by the Minnesota Society of Certified Public Accountants. For personal and small business information, visit www.mncpa.org or call (800) 331-4288.
