Is Your Portfolio Properly Structured?
By Ric Edelman
Do you know what the terms asset allocation, portfolio rebalancing, and diversification mean, and how to apply these concepts to your portfolio? You are not alone if you don’t. In a study of people who have $100,000 or more in investments, Hartford Financial Services Group found that few investors are familiar with the term “asset allocation.”
Of the respondents under age 24, none could explain the term. Only about 12% of those in their 20s and 30s said they knew what asset allocation means, and about 35% of those in their 40s and 50s claimed familiarity with the term. This lack of education is a big problem because asset allocation should play a crucial role in managing your investments properly.
Asset allocation refers to spreading your assets among different asset classes, such as stocks, bonds, CDs, real estate, gold, international investments, and natural resources. Within each asset class are sectors. For example, stocks can be parsed into growth and value; bonds can be split among government and corporate, and so on.
Therefore, educated investors know they should give equal consideration to how much money to place into an investment as well as to selecting investments that are appropriate for them. If you doubt the importance of asset allocation, consider this: Even if you buy the right investment at the right time, watching it double in value won’t do much for your finances if you had invested only 1% of your capital in that asset.
This is why smart investors focus on percentages, not dollars. The amount of money you have fluctuates daily. But the percentage never changes: You always have 100% of your money -- never more, never less. Therefore, instead of trying to decide how much money to place into a given investment, focus instead on the percentage you want there. Once you decide, for example, that you want 20% of your money in a given asset class, you know when to buy and when to sell.
How you allocate the assets in your portfolio depends on your goals and the time it will take to achieve them. For example, two people might own identical investments, but the person who is saving for a retirement that is 30 years away will allocate money among investments very differently from the person who is planning to pay for college in five years. That’s why professional financial advisors create asset allocation models for their clients, and do so only after developing a thorough understanding of the client’s goals. If you find yourself talking with an advisor who touts investments without regard to your goals, and without regard to asset allocation, you’re really dealing with a product salesperson, not a genuine financial advisor.
When properly executed, however, asset allocation contains an inherent flaw: It becomes outdated. That’s because no two asset classes (or sectors within asset classes, or individual investments within sectors) ever perform identically in any given time period. As a result, during a given period, some investments will rise or fall in value more than others. After a period of time, some investments will comprise a larger portion of your assets than you wanted, while others will comprise less.
That’s why asset allocators turn to portfolio rebalancing. If someone wanted, say, 65% of their assets in stocks and a review of the portfolio now reveals that stocks comprise 70% of total assets (because stocks rose faster than other asset classes), they’ll sell some of the stocks to bring the allocation back to the desired 65% level. Simultaneously, they’ll use the sale proceeds to buy more of the asset class that became underweighted (and we can guarantee that something is underweighted, since the total portfolio always equals 100%).
Rebalancing is important because if you don’t do it, your portfolio could eventually comprise too much of one asset class and too little of another. That could be devastating to you if something bad happens to the overweighted asset class -- as those who had placed all their money in tech stocks in the 1990s eventually discovered. Conversely, people who have too much of their money allocated to bank CDs could miss out on the potential profits available from other asset classes; in the worst case scenario, it could prevent them from being able to afford to retire.
The final element is diversification. How many securities should you own in a given asset class? After all, buying a single stock would be dangerous; buying two is half as dangerous, and buying four half-again as risky. At what point is enough, enough? A study in the Journal of the American Association of Individual Investors shows that a properly diversified stock portfolio is one that holds shares of 400 companies; doing so, the study says, reduces diversifiable risk by 95%.
Since ordinary consumers are highly unlikely -- or unable -- to own so many stocks (the security analysis, transaction expenses, paperwork, record-keeping, and tax reporting burden would be overwhelming), the approach preferred by most investors is to buy a stock mutual fund instead of individual stocks because this investment may provide the diversification an investor seeks.*
People who build and maintain portfolios based on asset allocation, portfolio rebalancing, and diversification may be likely to be successful investors.
*Asset allocation/diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a diversified portfolio will outperform a non-diversified portfolio.
Originally published in Inside Personal Finance October 2004