Asset Allocation

So you've decided to delve into the world of retirement planning. Now what? There seems to be no limit on either investment options or sources of information. Given that most of us don't have the time to learn everything we ever needed to know about investing, we will give you the key points first. You can then decide to delve into the details if you want.

The key point to remember: Don't put all your eggs in one basket.

The eggs are your savings dollars, and the basket is a single type of investment or single investment. So if you have $10,000 in savings, you don't want to invest all of it in a technology stock mutual fund. You would want to hold different types of investments. Likewise, you would not want to invest all of your savings in the local utility company's stock. You would want to buy at least a couple different companies' stock.

Now you know you shouldn't have your money invested in one investment type. But how do you move to the next step of figuring out how much money to hold in what types of investments? If you are like most people, you guess. There is actually a more scientific way to figure out the choice of baskets and how to split up your savings into those baskets. You can spend the time to learn all about the theory of asset allocation. It's just a bunch of math based on historical returns of different types of investments. But if you're like most people, you don't have the time or desire. This is where a financial planner or a tool such as GuidedSavings, comes into play. We do that math for you. And we keep on doing it. So as market conditions change, we change your portfolio to make sure you're always appropriately invested. If you want more information though, read on.

What Is Asset Allocation?
On the surface, this appears to be a relatively simple, although crucial, money management concept. By using asset allocation, what a financial planner aims to do is appropriately divide your investments among different kinds of asset classes such as stocks, bonds, and cash. That split is primarily based on your investment goals and the amount of risk you are willing to undertake when investing. The amount of risk you are willing to take should be based primarily on how much time you have until you need the money and how much money you currently have.

Here is where the math begins. The tools look at historical returns for different types of investments — cash, different types of bonds, and various types of stocks. From that data, the tools calculate the expected risk and the expected return for that particular type of investment. The risk is defined as the volatility of the returns for an investment. So if one investment returns 5.5% in year one, 5.3% in year two and 4.5% in year three, that would be far less risky than an investment that returns 53% in year one, -10% in year two and 24% in year three.

Now it's all about the numbers. The expected risk and return for each investment type is compared to that of every other investment type. Some will move in the same direction. Others will move in an opposite direction. The latter types provide the most benefit for asset allocation. In general, the theory states that when you mix investment types that move in opposite directions, you can actually improve returns for any specified level of risk. So when one investment has gone down in value, you are holding others that have gone up. Over time, you should be able to maximize returns for the risk you take.

All of this boils down to a curve on a graph, called the Efficient Frontier. Each point on the curve represents a mix of investment types, also known as an asset allocation, that provides the optimal amount of return for the level of risk. An investor's goal over time should be to find an asset allocation that places them on the Efficient Frontier. Your risk level determines your preferred point on the Efficient Frontier. As stated above, your risk level is based on how much time you have until you need the money and how much money you now have.

Why Is Asset Allocation "Powerful"?
The power of asset allocation was proven in a study conducted between the years 1973-1983 by Gary Brinson, L. Randolph Hood, and Gilbert Beebower entitled "Determinants of Portfolio Performance." These analysts examined the results of over 90 multi-million and multi-billion dollar pension funds to determine how and why their results differed.

By the culmination of the study, the team was able to explain almost 94 percent of each pension fund's performance based solely on knowing its method of asset allocation. Thus, the study concluded that the biggest single factor in explaining the performance of a portfolio is the asset allocation decision made to determine how much a fund holds each of the primary asset classes: stocks, bonds, and cash.

The study also concluded that, when investing for the long term, finding the right balance between foreign and domestic stocks and bonds is a much more important decision than which individual stock or bond fund you pick.

The Math Behind Asset Allocation
Taking what the researchers discovered about asset allocation to the next level will lead you to explore diversification options. As you begin to allocate your resources, you will want to diversify your investments among a variety of asset classes, such as stocks and bonds, that are unlikely to move in the same direction during market swings. By comparing historical risk and return of various assets, a correlation coefficient (r2) is calculated for each asset comparison. An r2 will always fall between -1 and +1. If the r2 for two assets is closer to -1, then the assets are negatively correlated. That means they move in opposite directions — when one is up, the other is down in value. Negatively correlated assets provide the largest benefit for diversification. If the r2 for two assets is closer to +1, the assets are positively correlated. Holding both assets will probably not help your asset allocation. Diversification through asset allocation reduces the risk that your portfolio might decline in value or fail to keep pace with inflation over the long run because your assets are balanced among various asset classes.

As stated above, the next step is to calculate the Efficient Frontier. This is where the math gets quite complex. Rather than reinvent the wheel, there is some great information out on the web. You will see consistent reference to Harry Markowitz, Ph.D. Dr. Markowitz is the architect of GuidedSavings. He also is the genius behind Modern Portfolio Theory, which encompasses the Efficient Frontier. You can find a lot of good information about the Efficient Frontier copying and pasting the following link address into your browser: http://viking.som.yale.edu/will/finman540/classnotes/class2.html.

GuidedSavings and Asset Allocation
By now, those investors with full time jobs and years to go until retirement are probably throwing up their hands in despair, wondering how they can cover all of these steps without it becoming a second career. This is where GuidedSavings portfolios — portfolios containing mutual funds in which assets are allocated appropriately — come into play.

The GuidedChoice experts use asset allocation to make recommendations for reaching your retirement goals. By determining your investment goals, the number of years you have to invest, your risk tolerance, and the availability of your financial resources, GuidedChoice is able to recommend which portfolio is the most appropriate for you to invest in. These portfolios are comprised of a variety of mutual funds and are positioned along the Efficient Frontier. A portfolio positioned along the Efficient Frontier will yield greater returns than a portfolio of a similar degree of risk that does not fall along the Efficient Frontier. In the long term, staying in a portfolio on the Efficient Frontier offers the most reliable way to get the best returns for a given level of risk.

Disclaimer: The views represented above are those of the author, and the information provided here does not constitute any tax, investment or legal advice. The historical data presented are for illustrative purposes only. Past performance is no guarantee of future results.