Asset AllocationAsset allocation refers to the process of dividing one’s wealth for investment in a set of distinct asset classes. Typical asset classes include domestic stocks, foreign stocks, domestic bonds, foreign bonds, cash (and cash equivalent instruments such as CDs and government Treasury-bills), real estate, etc. As an example, the outcome of an asset allocation process for one investor could be: Domestic stocks 35% If the investor had a total of $100,000 to invest and he elected to follow the example set above, he would invest the following amounts: Domestic stocks $35,000 Each of these asset classes is characterized by a typical risk and expected return combination. Riskier asset classes generally offer higher expected returns than less risky asset classes. Cash is the least risky. Cash instrument such as CDs are backed by government guarantees, making them effectively risk free. In contrast, foreign stocks, and especially those issued by small companies, are likely to be the riskiest investments. Studies have shown that the asset allocation decision (how much of one’s overall wealth is committed to each asset class) significantly affects overall portfolio value performance. At the heart of this is the observation that investments in the various asset classes don’t always move in lockstep. That is, when one goes up in value, others may decline in value. When investments tend not to move in lock step we say that they have low correlation. When investment values almost always move in the same direction, we refer to them as highly correlated. When two investments have a low correlation, it means that while one experiences a value loss, the others will likely move in the opposite, yielding a value gain. That value gain offsets the loss of the first investment, yielding what we refer to as diversification. As a general rule, low correlation allows for more diversification, while high correlation limits the potential diversification benefits. It should be clear that low risk coupled with high return is desirable. The ratio of return to risk can be raised by lowering risk and/or raising returns. A clever investor selects investments that provide diversification, as this effectively lowers risk while preserving return. By thinking in terms of correlations between asset classes, an investor can create an allocation scheme that takes the greatest advantage of diversification benefits. Another way to think about this is to say that the investor seeks to maximize the return given the level of risk s/he feels comfortable with. Alternatively, one can think in terms of minimizing risk while preserving a desired level of return. In either case the point is that based on how the investor feels about risk s/he can divide her money into a combination of asset classes that yield a comfortable risk/return tradeoff. An important observation is that an investor’s preferred asset allocation mix is specific to that investor’s feelings about risk. This is sometimes referred to as the investor’s risk tolerance or risk aversion. In order to help an investor to measure his or her own risk tolerance, s/he is often asked to respond to a series of questions. The responses help to determine risk preferences. In this chapter of the book we provide information about various sources an investor can turn to in order to generate an asset allocation scheme. In each case, the investor must respond to a short number of questions. For additional information about asset allocation refer to the SEC site. Determining Your Asset AllocationFactors Affecting Asset Allocation |
Passive Investing Steps
