Investment Portfolio Asset Allocation Insights

Our intention is to make it easier for our subscribers to make profitable investment decisions. We do this at a couple levels. First, we save you the time it takes to do the general research required to narrow down your investment choices. Second, we give you our insights on selections so you can make your own well-informed decision on what to have in your portfolio.

Before you get started investing in today’s economy, it is imperative that you have enough money saved in the bank, or a money market fund,to cover your expenses for a year in case of emergency. If you are one of the many people that have already had to dig in to your savings because of a job loss, the first thing you should do when you get back to work is to reestablish your emergency fund.

Once you’ve taken care of that, it’s time to consider your savings, investment, and retirement plans.

The first aspect to consider for your investment plans is your personal tolerance for risk. The amount of risk you are willing to take is an extremely important factor to consider before making an investment because of the severe consequences of taking on too much risk. Risk is uncertainty the possibility that the investment won’t perform as expected. Investors who take on too much risk often panic when confronted with losses that are larger than they are anticipated. A frequent response of these investors is bailing out of a losing investment at the worst possible time, its lowest point.

The best approach to measuring risk is simply to examine the worst-case scenario for a loss over a one-year period and ask yourself whether you could stick with your investment plan in the face of such a loss.

Investors with a low tolerance for risk generally can sustain losses of no more than 5% over a one-year period. While money market funds and short-term bond funds are good investments for protecting your underlying principal, your earnings will hardly keep you ahead of inflation.

Investors with a moderate tolerance for risk generally can withstand losses of 10% to 15% over a one-year period. Intermediate-term bond funds and value stock funds may sustain these kinds of losses.

Investors with a high tolerance for risk generally can withstand losses of 20% or more annually. While these types of losses are most often associated with aggressive growth funds, small cap stock funds, and technology funds, as we’ve seen in the last few years, even blue chip stock funds can sustain losses in this range.

There are a few trade-offs to consider when evaluating a potential investment for your portfolio. First, depending on the risk/reward profile of an investment the higher your expected reward, the higher the potential risk. In other words, the “cost” for principal protection is lower returns. Second, there is a trade-off between income and growth. The more certain the annual payment, the less risky the investment, and as a result the lower the potential return in the form of growth. This ties in closely with the third consideration, your time horizon. In short, the sooner you need to take your money out of an investment, the less risk you can afford to take. The risk/return equation increasingly favors stocks over bonds for longer holding periods. Diversification, over different asset classes and time horizons, is an important technique for improving an investor’s returns while reducing overall risk.

Think of every item you are saving for as a bucket you can put money into. Some categories to consider: a new home, college for the kids, 401K plans, self-directed retirement accounts (IRA, Roth IRA, SEP, etc.), and long-term investments. The key thing to think about here is your time frame.

Any money you are going to need within the year should be in a money market fund. If your time frame is 1 – 3 years consider a short-term bond or short-term municipal bond fund if you are above the 25% tax bracket. Beyond that, it should be considered a long-term investment, so it should be allocated between asset classes, taking more risk with money you do not expect to need in less than 5 years.

One final issue when choosing an investment is its potential effect on your taxes. Since the current tax laws provide for lower tax rates on stock dividends and long-term capital gains, unless you need the income to live on, most of your bond funds should be in your retirement account. In addition, large cap value funds, small cap stock funds, and municipal bond funds fit better in your taxable accounts.

While we cannot provide individual advice on your specific investments, we have set up model portfolios that focus on different types of investors. In addition, we have portfolios that deal with taxable, as well as, tax deferred portfolios. The Conservative Portfolios are for people that have a low to moderate tolerance for risk or for investors nearing retirement. Our Insightful Portfolios are for people with moderate to high risk tolerance or for investors with a long time horizon before retirement. The Retirement Portfolios are for people who are retired that want to generate some income from their portfolio, preserve their capital, and allocate some of their assets to growth.


Asset Allocation

The goal of asset allocation is to either reduce portfolio risks without substantially affecting overall return, or to enhance returns without substantially adding to those risks, hopefully both.

The best approach to reducing stock market and interest rate risks is to find segments within the stock and bond markets that are affected by different kinds of factors. While one segment of the market may be down, the other segment may be less affected, providing higher returns over that period. The overall affect of combining these segments is to smooth return variations-and less variation means less risk-without reducing return.

The first step in the asset allocation process is to divide your portfolio into stocks, bonds, and cash. Each of these asset classes has its own risk profile.

Cash – While cash is the safest investment choice for capital preservation, your biggest risk in keeping all of your investments money market funds is that you will not even keep up with inflation. That being said, we feel you should always maintain a portion of your portfolio in cash to take advantage of good investment opportunities.

Bonds – These securities will keep your portfolio ahead of inflation in the long run, but bond returns vary inversely with interest rates. During a strong economy interest rates usually rise, affording investors a higher yield, but the bonds themselves fall in value. On the other hand, when interest rates are falling, bond yields fall as well, but the value of the bonds increases. The fluctuations in interest rates will cause the total return on bonds to fluctuate, with long-term bonds fluctuating more than short-term bonds.

The major bond market segment that most investors concentrate on is U.S. government bonds, high-grade corporate bonds and high-grade municipals. These bonds are impacted most by interest rates and perform best in a weak economy. High-yield bonds, on the other hand, tend to do best in a strong economy. Firms that have an uncertain financial outlook usually issue high-yield bonds. Investors in these bonds are compensated for taking that additional risk with higher interest rates.

Stocks – Investing directly in companies through the stock market provides an investor with the highest potential for the growth of their capital while at the same time exposing the investor to a substantial risk of losing their capital. While stock returns can be influenced by interest rates, the most important factor is the condition of the economy.

The biggest segment of the stock market consists of the large, well-established companies that make up the Standard and Poor’s 500. The stocks of these firms offer potential for growth as the economy expands. In addition, many of them also offer some income in the form of cash dividends.

While large companies offer more stability, the stocks of smaller companies have shown a greater potential for long-term growth. The trade off for higher potential returns is additional risk and more volatility. The same can be said about stock of companies outside the United States. Although it can be harder to obtain information to analyze these firms, there is room for both of these asset categories in every investor’s portfolio.

You can read more about our Asset Allocation Models if you are interested our experience with building them.

For more general investment information, Please read our Mutual Fund Investing Page, our ETF Page, or our 401k Investing Page. To find out our latest insights on the financial markets check out our Investing Newsletter.