Understanding Asset Allocation
Many investors mistakenly believe they can get all the diversification they need by holding a variety of different companies in their portfolios. Unfortunately, such thinking is totally off base!
Asset allocation does NOT mean diversifying among different securities. You can prove this quite easily by looking at the NASDAQ 100 which holds 100 different stocks, but has only a very slight diversification value.
Instead, asset allocation means diversifying among different classes of financial assets. Sometimes investors think of this as just dividing their money between stocks, bonds and cash. But true asset allocation goes much further.
Within the category of stocks, there are large-caps and small-caps, foreign and domestic, growth and value, etc. Then, within the bond category, there are governments and corporates, high-grade and high-yield, inflation-adjusted treasuries, mortgage bonds, etc. And the beauty of asset allocation is that it allows you to take these non-correlated assets (assets that don't move in tandem) and combine them in such a way that you maximize your returns while minimizing risk.
Here's an example of what we're talking about. If you had invested in the S&P 500 for 30 years, ending on December 31, 2001, your money would have compounded at 12.2% a year. Not bad you say?...Perhaps. But if instead of just holding the S&P 500, you asset allocated your portfolio to hold 50% S&P 500, 25% foreign stocks, 20% small cap stocks and 5% real estate investment trusts (REITs), you would have experienced less volatility, fewer down years, and beaten the S&P 500 too!
But it gets even better. You could have been even more conservative. A portfolio that was 40% S&P 500, 20% foreign stocks, 16% small caps, 4% REITs and 20% bonds would have been considerably less volatile, had fewer losing years, and still beaten the S&P 500! And none of these figures include the even higher returns you would have achieved if you had simply rebalanced the asset allocation in your portfolio once a year.
The reason it's crucial that you have this knowledge is because the vast majority of investors accept as gospel the conventional wisdom that higher returns require greater risks. They don't. Independent research on asset allocation repeatedly demonstrates this basic truth.
Unfortunately, talking about asset allocation isn't anywhere as thrilling as discussing the latest takeover target or the next hot IPO, but it hapens to be essential to managing your money intelligently. In other words, it's all about taking smart risks, not big risks.
* * * * *
Asset allocation does NOT mean diversifying among different securities. You can prove this quite easily by looking at the NASDAQ 100 which holds 100 different stocks, but has only a very slight diversification value.
Instead, asset allocation means diversifying among different classes of financial assets. Sometimes investors think of this as just dividing their money between stocks, bonds and cash. But true asset allocation goes much further.
Within the category of stocks, there are large-caps and small-caps, foreign and domestic, growth and value, etc. Then, within the bond category, there are governments and corporates, high-grade and high-yield, inflation-adjusted treasuries, mortgage bonds, etc. And the beauty of asset allocation is that it allows you to take these non-correlated assets (assets that don't move in tandem) and combine them in such a way that you maximize your returns while minimizing risk.
Here's an example of what we're talking about. If you had invested in the S&P 500 for 30 years, ending on December 31, 2001, your money would have compounded at 12.2% a year. Not bad you say?...Perhaps. But if instead of just holding the S&P 500, you asset allocated your portfolio to hold 50% S&P 500, 25% foreign stocks, 20% small cap stocks and 5% real estate investment trusts (REITs), you would have experienced less volatility, fewer down years, and beaten the S&P 500 too!
But it gets even better. You could have been even more conservative. A portfolio that was 40% S&P 500, 20% foreign stocks, 16% small caps, 4% REITs and 20% bonds would have been considerably less volatile, had fewer losing years, and still beaten the S&P 500! And none of these figures include the even higher returns you would have achieved if you had simply rebalanced the asset allocation in your portfolio once a year.
The reason it's crucial that you have this knowledge is because the vast majority of investors accept as gospel the conventional wisdom that higher returns require greater risks. They don't. Independent research on asset allocation repeatedly demonstrates this basic truth.
Unfortunately, talking about asset allocation isn't anywhere as thrilling as discussing the latest takeover target or the next hot IPO, but it hapens to be essential to managing your money intelligently. In other words, it's all about taking smart risks, not big risks.
* * * * *
posted by Bob Moser at
7:54 PM
1 Comments:
Diversification minimizes risk but does NOT maximize gains as the article states.
By
Anonymous, at 8:32 PM
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