The Basics of Asset Allocation

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Whenever you talk to an investment professional, she invariably mentions the importance of asset allocation. Closely linked to the discussion of asset allocation is the concept of diversification. Both are considered useful in designing and managing an investment portfolio.

Think of asset allocation as placing your proverbial eggs in three main categories of baskets: equities, fixed income, and cash equivalents. Refinement of asset allocation and diversification involves figuring out what types of baskets (such as large-cap blend and small-cap growth equities, technology and manufacturing sectors, etc.), and then choosing specific investments within those types. (See also: A Guide to Online Brokers for Investing Newbies (and Beyond))

Rationale for Asset Allocation

Many professional advisers and websites will mention Modern Portfolio Theory (or MPT) as the foundation of asset allocation. An idea crystallized and explained by Harry Markowitz (who won the 1990 Nobel Prize in Economics for his efforts), portfolio theory suggests that proper asset allocation is instrumental in optimizing portfolio return, given a specific risk tolerance.

Others in the investment field simply promote the idea of allocating assets into various classes and diversifying within sub-classes or categories. This technique is useful for

1. Managing risk and volatility.
    
2. Capturing gains from the asset class along with the sub-class, sector, etc. that experiences growth during certain time periods.

From what I can discern, the main difference between the two schools of thought is a nuanced one. Portfolio theory claims that proper asset allocation can optimize investment returns by locating the efficient frontier or sweet spot in an investment portfolio. Others indicate that you may need to sacrifice returns somewhat in order to minimize risk. Either way, asset allocation and diversification are employed to help investors reach their goals.

The underlying assumption based on historical performance is that different asset classes along with sub-classes, categories, and sectors perform better than others at any given time. For example, the prices of large-cap value stocks may grow at a rapid pace and small-cap growth stocks may falter under certain market conditions; however, small-cap growth mutual funds may soar when large-cap value funds decline.

How different asset classes (and individual investments) move in relation to each other is known as correlation. If asset categories move in the same direction, they are positively correlated; in the opposite direction, negatively correlated. Asset allocation and diversification help manage this correlation so that fluctuations in investment returns stay within certain ranges based on risk tolerance. For an illustration of this concept, see the graph on Model Asset Allocation Plans from Charles Schwab.

Factors Affecting Asset Allocation Models

Most investment professionals and online investing tools create asset allocation models based on your risk tolerance and time horizon (or your current age). In general, stocks comprise a higher percentage of the overall recommended portfolio the higher your risk tolerance and the longer your time horizon. However, each model is designed slightly differently, so percentages assigned to asset classes vary. (See also: Using Time Horizons to Make Smarter Investments)

Your personal circumstances and economic conditions may lead you to alter a model asset allocation. For example, I feel comfortable investing more heavily in equities than generally recommended, so my ideal differs slightly from those proposed by asset allocation tools.

Whatever your model, define and stick with its breakdown into various classes unless you have a compelling reason to change.

Using Asset Classes and More for Asset Allocation and Diversification

There are many sources, such as online tools as well as certified financial planners, that can provide guidance regarding asset allocation and diversification methods.

Some offer general direction, specifying percentages for large-cap stocks, small-cap stocks, foreign stocks, bonds, and cash equivalents (such as this tool from CNN Money); whereas others give more detailed guidance. Note that this breakdown goes beyond main asset classes central to asset allocation and includes sub-classes, categories, sectors, etc. important for diversification.

Portfolio analyzers often give comparisons of current holdings to target allocations based on risk tolerance. Also, there are diversification tools that help build and manage a portfolio alongside of asset-allocation illustrations. (See also: 5 Best Online Brokerages)

Here are a few ways holdings may be classified and evaluated using portfolio analysis capabilities provided by these popular online brokerage firms:

TD Ameritrade

• Asset Allocation: Domestic Equity — Large Cap, Mid Cap, Small Cap, Other; International Equity — Developed, Emerging, Other; Specialty; Domestic Fixed Income; International Fixed Income

E*Trade

• Asset Class: Stocks, Bonds, Cash
   
• Valuation: Value, Core, Growth
   
• Sector: Cyclical (Basic Materials, Consumer Cyclical, Financial Services, Real Estate); Defensive (Consumer Defensive, Healthcare, Utilities); Sensitive (Communication Services, Energy, Industrials, Technology)
   
• World Regions: U.S. & Canada, Europe, Japan, Latin America, Asia & Australia
   
• Stock Type: High Yield, Distressed, Hard Asset, Cyclical, Slow Growth, Classic Growth, Aggressive Growth, Speculative Growth

How to Use Portfolio Recommendations

Many portfolio management tools are comprised of three key components:

1. Recommended allocations
    
2. Current distribution among asset classes and categories
    
3. Changes recommended because of differences between the ideal and existing asset mix

High-level recommendations generated through online functionalities seem to be reasonable. For example, you may want to increase your holdings in international stocks and small-cap stocks if your portfolio is comprised mostly of large-cap stocks. Similarly, sector analyses may indicate ways you can diversify through greater concentration in utilities and healthcare and less in industrials, for example.

However, more pointed recommendations, such as sell ABC stock or XYZ mutual fund and buy this one, tend to be less helpful. Take the suggestions as a starting point for further research rather than the ultimate answer about what you should do next with your portfolio.

Rebalancing

If your portfolio grows in the way that asset-allocation proponents predict (that is, certain asset classes grow and become over weighted when others languish or decline and become underweighted), then you'll need to rebalance. Review your current portfolio and make adjustments yearly or perhaps quarterly or whenever huge growth occurs and prompts the need to rebalance.

To return your portfolio to its equilibrium, sell off the high-performing assets and increase your position in the other assets, or invest new money in the lower-performing assets. That is, buy more of what didn't perform well recently, so your portfolio will be positioned to capture gains in areas poised for growth. These rebalancing steps seem counterintuitive but are essential to maintaining your portfolio's asset allocation. (See also: Investment Allocation by Age: Birth to 10 Years Old)

Asset allocation, diversification, correlation, and portfolio theory can get complicated. Financial professionals may oversimplify concepts (and occasionally draw misleading conclusions) for the purpose of championing thoughtful portfolio design as well as promoting an investment product and selling a service. Knowing the basic lingo of asset allocation can help you understand and participate in these conversations and make informed decisions for building and managing your portfolio.

Have you employed asset allocation in managing your investments? Are you satisfied with the results?

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