Ask The CFP® Practitioner
The shoe that fits one person pinches another; there is no recipe for living that suits all cases.
- Carl Jung, Swiss Psychologist, 1875-1961
Question: What is asset allocation and how does it work?
Answer: Asset allocation involves combining various types of investments using a mix or a recipe that’s right for you. For instance, pasta, pancakes, and bread are all very different, yet each consists of various amounts of flour, eggs, water, or milk. Depending on the quantity of each ingredient, you’ll get a very different outcome. The same is true with your investments.
Getting the right mix Asset allocation is a technique used to appropriate investment dollars across several asset categories. Stocks, bonds and cash or cash alternatives are the most common components. The combination of investments selected may be as important as the specific investments. Some investments are chosen for growth potential while others may provide regular income. Each type of investment has specific strengths and weaknesses allowing it to play an exact role in your overall plan. Ideally, the objective of asset allocation is to minimize volatility while maximizing return. The goal is to accomplish this by dividing your investment dollars among asset categories that don’t all respond market forces in the same way at the same time.
Personal preferences My husband makes a mean pasta sauce, but it’s a bit mild for my liking. To solve this, he transfers a portion to another pot and adds crushed red peppers for pizzazz. When the kids are in town, he further modifies the recipe leaving out the mushrooms to suit their tastes. You get the idea, personalization and customizing a recipe is a lot like building an investment portfolio.
The number of asset categories selected and the percentage of dollars allocated to each category depends, in large part, on the size of the portfolio, tolerance for risk, investment goals, and time horizon or how long the funds will remain invested. A simple portfolio may include as few as three investment categories, dividing dollars among cash or cash alternatives, bonds and stocks.
The primary purpose of asset allocation is to adhere to certain investment objectives. Even if your current recipe or allocation is appropriate, it shouldn’t necessarily stay the same forever. What was appropriate in the past may not be right today, and what works today may not be right for you in the future. This can be the result of a variety of factors, including:
1) Changes to investment objectives and priorities 2) Economic fluctuations 3) Growth or decline within asset classes that require shifting funds from one asset class to another to return the ratios you’ve determined are appropriate for your portfolio.
Changes to any of these factors may indicate that it’s time to reexamine your asset allocation. Regular monitoring allows you to adjust the recipe to correspond with current circumstances although too frequent rebalancing may be detrimental. This is why portfolio management is both an art and a science, just like cooking.
Many publications feature model investment portfolios recommending generic asset allocations based on age. These can help frame your thinking about how to divide assets. However, don’t view them as definitive because they’re based on averages and hypothetical situations.
Your asset allocation is, or should be, as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. This may mean moving funds from higher-risk (spicier) to lower-risk (milder) investments to coincide with your preferences.
Tax time or year-end is often a good time to check up on your portfolio and think about making any necessary adjustments. At a minimum, you should check it when there are significant changes in your life.
Determining an appropriate asset allocation may be the most important single investment decision you make. It will likely have more impact on your overall return than the selection of individual investments. Don’t hesitate to get expert help if you need it. Stay focused and invest accordingly.
Investing involves risk and the possible loss of principal invested, investors may incur a profit or a loss. There is no guarantee any particular investment strategy will be successful. Asset allocation alone cannot ensure a profit or eliminate the risk of a loss.
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Darcie Guerin, CFP®, is Associate Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email firstname.lastname@example.org. www.raymondjames.com/Darcie