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The Basics of Asset Allocation

The Two Biggest Investment Mistakes:

1. Failure to diversify. Don’t bet everything on one stock. Don’t put all your money into either stocks or bonds.
2. Failure to cope with inflation risk. Today you need over $2 to buy what $1 bought in 1980, over $4 to buy what $1 bought in 1971.

Have you set specific, realistic investment goals? Is your current investment program structured to realize those goals without exposing you to any more risk than absolutely
necessary? How aggressive, or defensive, do you want to be?

If you’re like many busy people, you may profit in years to come by tuning up your investment planning now.

Take a long-term perspective

Returns on stocks and on bonds vary enormously from year to year. That year-to-year uncertainty spells high risk. To eliminate much of the risk, define long-term investment goals and stick to them. Investment returns over periods of five or ten years are much less volatile.

Expect to tap some of your investment capital within the next two to three years—for college bills, perhaps? To play it safe, set aside in money market funds or other short-term investments the dollars that you will need.

When investing for the long term, inflation becomes a major risk. Since World War II, investments in Treasury bonds or “risk-free” Treasury bills scarcely have kept pace with inflation, even before subtracting taxes. By contrast, common stocks have enabled long-term investors not only to keep pace with inflation but also to build real wealth.

Spread the risks

As an investor, you cannot avoid risk altogether, but you can control your risks. Although common stocks promise the highest returns in the long run, it’s safer to own more than one type of investment asset. Different classes of investment assets are subject to different market forces. Thus, one market may be heading up while another is going down. As a result, investors can reduce risk (year-to-year price volatility) simply by diversifying among asset classes.

For example, some investors hold only bonds, avoiding stocks as “too risky.” Yet studies show that investors who own both stocks and bonds should be able to enjoy lower overall risk as well as higher returns.

Two low-risk approaches to bonds

When interest rates rise, bond prices inevitably fall. What’s more, prices of long-term bonds—those that won’t mature and be redeemed for 20 or 30 years—tend to fluctuate more violently than the prices of bonds that mature in five or ten years.

Bond investors can deal effectively with this risk in two ways:

1. Match the maturity of your bonds to the time when you will need to cash in on your investment. If your youngster is due to start college in the year 2010, and you’re investing the first-year tuition money in bonds that mature in 2010, the bond market’s gyrations won’t affect you.

2. Diversify by maturity. That is, put some of your bond money into short-term bonds or bond funds, some into intermediate maturities and some into long-term bonds. You’ll still obtain relatively good income, and you won’t be exposed to as much market risk.

You’re not the average investor

Financial gurus often talk about “efficient” investing. The idea is to design an investment mix that provides an acceptable return with an absolute minimum of risk. But the best theoretical investment formula won’t necessarily fit your long-term goals or fill your current income needs. Or it might not make good sense in light of your overall financial picture.

That’s why you need an investment plan that is tailored specifically to your circumstances. We can guide you on this all-important asset allocation decision.

The post The Basics of Asset Allocation first appeared on Advisors to the Ultra-Affluent – Groco.


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