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Picking the right asset allocation for your situation is as important as picking specific mutual funds. Your asset allocation will determine in large part how risky your portfolio is and what returns you can reasonably expect. Over the next week, we’ll look at allocating your investments between various asset classes (e.g., stocks and bonds, large cap and small cap, U.S. and International). To pick an appropriate asset allocation for your situation, however, it’s important to understand the purpose and goals behind asset allocation.

Why Not Pick The One Asset Class That Historically Has Returned The Most?

In the first part of this series, we looked at several asset classes and discussed the historic returns they have generated. From the period 1945 to 2001, for example, small cap U.S. equities have had the highest annual return of any asset class, clocking in at 14.5%. So why not just invest everything we’ve got in small-cap U.S. equities, particularly if we have a long time (say 20 or more years) before retirement?The answer to this question underscores one of the primary benefits of investing in multiple asset classes–we don’t want to put all of our eggs in one basket. While asset allocation relies in part on historic returns, there is no guarantee that these returns will continue indefinitely. Over the next 50 years,

The answer to this question underscores one of the primary benefits of investing in multiple asset classes–we don’t want to put all of our eggs in one basket. While asset allocation relies in part on historic returns, there is no guarantee that these returns will continue indefinitely. Over the next 50 years, small-cap U.S. equities may underperform one or more asset classes. We just don’t know.

There is another reason we don’t want to put all our eggs in one basket–risk. It’s tempting to look at the returns of a mutual fund or asset class without considering the investment’s risk. Returns are easy to understand, while the concept of risk is often obscured behind statistical terms such as standard deviation, or worse, Greet letters such as alpha and beta.

We don’t need to dive into the theory behind risk, though, to appreciate one key aspect of asset allocation–proper asset allocation can reduce a portfolio’s risk by investing in asset classes whose returns do not all go up and down in lock-step. Known as cross-correlation coefficient, or just correlation, the idea is that while one asset class (say stocks) is going down, another asset class (say bonds) you own is going up or at least is not going down as much.

Finally, we should consider our own emotions. Investing 100% of our portfolio in small-cap stocks would require us to weather substantial paper losses in bad years. Many investors simply can’t handle the volatility. Selling in these down markets would produce awful investing results.

What to Consider in Picking an Asset Allocation

There are several things to consider when picking a proper asset allocation:

  • Your Risk Tolerance: Risk is one of the primary considerations in developing an asset allocation. Although we will look at a number of asset allocations, the choice between stocks and bonds is arguably the single most important determinate of a portfolio’s risk. For me, I look both at how much risk I believe I can stomach, and how much risk I need to stomach. This second point cannot be overstated. Recently, an interview with Suze Orman revealed that much of her $25 million portfolio is in bonds. While this at first may seem odd given what she does for a living, she may not need to take on any additional risk given the size of her portfolio. For all of us who don’t have $25 million laying around, let’s keep reading.
  • Desired Returns: Returns and risk go hand in hand. Understanding what return you need to achieve to reach your financial goals will play a part in picking the right asset allocation for you. I should caution, though, that setting unrealistic return goals and taking on more risk than you should will often prove counterproductive.
  • Your Mutual Fund Options: The reality for many is that their investment choices are limited to the mutual fund options in their company’s 401(k). While you may want to include REITs or Emerging Markets in your asset allocation, your 401(k) may not offer those options. Of course, you can invest in these asset classes outside of your 401(k) if you have the resources to do so. If your 401(k)’s options are lacking, you may want to talk to your employer about adding new options. I did that where I work, and eventually, more than 200 mutual fund options were added to our 401(k).
  • How Much Money You Have to Invest: This may seem like an odd consideration, but when you first start out saving a relatively small amount in your 401(k), you probably don’t need 10 asset classes. As I discussed in How To Pick Your First Mutual Fund, a relative of mine started out with just an S&P 500 Index fund (large U.S. companies). She will certainly add other asset classes as her portfolio grows, but the single core fund was a good place for her to start.
  • Simplicity: The KISS (Keep It Simple Stupid) principal can go a long way here. As we will see in the third part of this series, there are a number of different ways to implement an asset allocation, ranging from a single mutual fund to more than a dozen. Your appetite for complexity will determine just how you want to implement your own asset allocation. Just remember that as a portfolio’s complexity grows, so does the time it takes to manage it.

There are many good resources that discuss the theory and practice behind asset allocation. If you have the interest, I highly recommend two books on the subject. The first is The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk. Written by William Bernstein, this is an excellent and easy to understand description of the theory and practice of asset allocation. The second book, written by David Darst, is The Art of Asset Allocation : Asset Allocation Principles and Investment Strategies for any Market. This book is more focused on theory, but also provides an excellent analysis of historic returns and the rationale underpinning asset allocation.

Tomorrow we’ll look at allocating your investments between stocks and bonds.

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Listen to my interview of Paul Merriman on his Ultimate Buy and Hold Portfolio:

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