Understanding asset allocation: Part 2
Last week I attempted to establish the primacy of asset allocation as an investment strategy, i.e., it should be the first step in the investment process for any investor. To reaffirm this position, I would cite the following appropriate remarks from the American Association of Individual Investors’ Investor Classroom Web site:”At first glance, many investors assume that the basic asset allocation decision is easy. After all, at this level you are focusing on only three choices – stocks, bonds and cash. While the choices are few, the way you allocate your portfolio among these three categories will have by far the greatest impact on your performance of any investment decision you make.”The message is pretty clear. However, for many individual investors, making the “right” decision isn’t always so easy. In last week’s Part 1, I discussed a number of practical asset-allocation guidelines that investors need to consider. I’ll continue here with some additional perspectives: • In most instances, investment advisory literature describes investment strategies as being a choice of being an aggressive, moderate or conservative investor. I would suggest that investors think more in terms of taking above-average, average and below-average risk to meet their investment objectives.This isn’t just a case of semantics. Risk is an inherent part of investing. Risk produces the returns we need to build an adequate retirement fund. We don’t want to lose money either, so we manage risk through asset allocation. Other risk management tools include investment diversification, long-term investing horizons, and the selection of high quality securities and funds for a retirement portfolio.• Don’t be misled by overly simplistic determinations of your risk tolerance. For example, 401(k) and similar retirement-plans distribute brochures with the ubiquitous “risk quiz.” You answer a dozen questions and, bingo, there’s your risk-tolerance profile, which is then used to determine your asset allocation.Does this sound like the best way to make the single most important financial investment decision you’ll make in your lifetime? I don’t think so, particularly when you’re being tested on a subject matter (investment risk) you most likely know very little about. It’s like me being asked about computer software when all I know about computing is how to use the on and off switch on my desktop. • I’ve seen a lot of investment education material that mixes up investment diversification with asset allocation. This circumstance is confusing and can cause investing mistakes. We know that asset allocation guides us toward what percentage of our invested funds should go into equities, fixed-income and cash. After this key first step, our second step, diversification, involves the selection of the type of stock, fund and cash equivalent we want to use for each of these asset classes.This process is called investment diversification and is distinct from asset allocation. The former involves choosing individual stocks, mutual funds and exchange-traded funds according to company size, investment style, industry sector, geographic scope, etc. for the equity category. Similarly, with fixed-income and cash, considerations of credit quality, maturity, yield, etc.. determine what individual securities and/or funds we select. • Lastly, so-called life-style or target mutual funds provide for automatic asset allocation and diversification within a single fund according to age, risk tolerance or retirement date throughout the lifetime of the investor. For the investor, the whole investment process goes on “auto-pilot.” However, be aware that these one-size-fits-all funds often don’t fit so well with all individuals, tend to limit an investor’s flexibility and can be a bit expensive. In summary, asset allocation is one of the most important tools investors have to manage risk and return. Used prudently, this first step in the investing process serves as a solid foundation for building a retirement nest egg over the long term.The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 827-5591 or email@example.com.Vail, Colorado
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