Posted on October 21, 2008

Retirement Investing Basics: Asset Allocation

the asset allocation puzzle

Ask any financial advisor how to invest for retirement, and his or her answer will invariably include the term “asset allocation.” What, exactly, does that mean? And how can you apply it to your own situation? This article aims to answer these questions.

Asset Allocation Defined

Asset allocation can be defined as the process of spreading or “allocating” money across several different types of investments, e.g. stocks, bonds, CDs, real estate, precious metals, and so on.

Of course, anyone who owns more than one type of investment has, by definition, allocated money among assets. Asset allocation, however, is generally taken to mean doing this systematically, e.g. by routinely adjusting one’s portfolio in such a way as to keep a specific percentage of the total in each asset class. For example, a retiree may decide that 50% of his or her portfolio should be invested in a bond fund, 15% in a money market fund, and 35% in a stock market fund. As the values of stocks and bonds fluctuate, money will be moved from one fund to another to keep the percentages as constant as possible.

Why Practice Asset Allocation?

There are three primary reasons why asset allocation is a wise investment strategy:

1. Diversification and risk reduction. Simply put, asset allocation helps investors to avoid “keeping all their eggs in one basket.” By allocating among several asset classes that are expected not to move in lock-step, investors can hope to counterbalance losses in one asset class with gains in another.

2. Tailoring the investment portfolio to personal needs. Over time, stocks have generally outperformed bonds and cash-like investments such as money market funds. Stocks, however, tend to be much more volatile and subject to “boom and bust” cycles. Young investors who will not need to sell their investments for decades can therefore allocate a large portion of their portfolio to stocks. Retirees who expect to gradually draw down their portfolio for living expenses will allocate more to bonds and money market funds so as not to be forced to sell stocks during a market downturn.

3. Avoidance of emotional risk factors. Everyone wants to “buy low and sell high,” but it is impossible to predict market fluctuations. By deciding upon, and sticking to, an asset allocation strategy, investors can avoid the temptation to panic-sell the stock portion of their portfolio after market drops, or to overinvest in stocks when the market has gone up-up-up, and may be heading for a fall.

Asset Allocation Strategies

How does one put the principle of asset allocation into practice? Here are some strategies:

1. Always look at your total portfolio. Don’t make the mistake of viewing your 401(k), IRA, Roth IRA, and personal savings as independent of one another. Rather, look at your total portfolio, and be sure that the percentages allocated to the various asset classes of stocks, bonds, and so on, make sense.

2. Use a limited number of mutual funds as investment vehicles, and limit, or eliminate, investments in individual stocks. Mutual funds, by definition, spread investments over a large number of investments within any given asset class. Stock funds represent a pool of dozens, usually hundreds, of different individual stocks. Bond funds invest in many different bonds. To keep your portfolio understandable an easy to manage, avoid investing in many different funds that have a similar purpose. For many people, a stock-market index fund, a Ginnie Mae fund for fixed income, and a money market fund will be enough. Others may add an international stock fund and a short-term bond fund. Individual stocks greatly increase risk, since any corporation can suddenly fall upon hard times. If you have more than 5% of your portfolio in any single stock, consider trimming or eliminating this holding, and reallocating to mutual funds.

3. Determine your asset allocation percentages, and stick to them. Don’t try to sneak “outguessing the market” back into your strategy by reallocating assets based on hunches, e.g.: “the stock market is low right now so I’ll allocate more to stocks.” Remember that nobody knows which way the market is going. You may, however, change your allocation as your personal risk tolerance changes. As you get older, you’ll normally reduce holdings of stock mutual funds and increase bonds and money market funds.

4. Be aware of tax consequences, but don’t let the tax tail wag the allocation dog. Dividends and capital gains enjoy tax advantages over interest payments. Therefore, wherever possible, you’ll want to put the fixed-income portion of your portfolio into tax-favored accounts such as IRAs. Stock funds, which produce most of their profits through dividends and capital gains, can be held in non-tax-favored accounts. But don’t obsess about this. It’s more important to have a good overall asset allocation strategy than to shave percentage points off your taxes.

Asset Allocation Guidelines

If you’ve decided to practice asset allocation, what percentages should you use? Here are some guidelines.

1. Stock funds. An old rule of thumb says that 100 minus your age should be invested in stocks: if you’re 35, 100-35 or 65% of your portfolio should be in stock funds. Depending on your temperament, you can vary this amount. An aggressive 35 year old may put 80% into stocks; a very conservative one, only 50%. Beware of being too conservative, however. The more you “protect” yourself against stock market fluctuations by investing in money markets or fixed income, the less real protection you have against inflation.

2. Money market funds. These funds invest in short-term bonds that are subject to only very little fluctuation. The share price is generally fixed at $1.00. This means that money market funds function much like a savings account: the principal doesn’t fluctuate, but interest rates go up and down with the market. Return on investment is generally low compared to other investments. Put as much into a money fund as you will need over the next few years. If you’re still far from retirement, you can forego this investment altogether.

3. Fixed income funds. Such funds include bond funds and Ginnie Mae funds. “Fixed income” does not mean that these funds don’t fluctuate: when interest rates rise, these funds lose in value. After determining how much you should invest in stocks and money market funds, you can put the remainder into fixed income funds.

4. Inflation protected funds. These are a relative newcomer to the investment world. The U.S. government issues TIPS, or Treasury Inflation Protected Securities, which are then held in these funds. They generally offer lower returns than fixed income funds but greater stability and safety. If you fear future inflation, a portion of your fixed income portfolio can be invested here.

5. Other investments. These include REIT (real estate investment trust) funds, precious metals and mining funds, and sector funds (e.g. health care, technology, and so on). REITs can provide rising income over time plus capital gains as real estate appreciates. Due to the real estate “bust,” they are currently depressed in price. Those wishing to incorporate the risks, and rewards, of real estate into their portfolio can allocate a small percentage to REITs. Precious metal funds often move in the opposite direction from inflation expectations. Like inflation protected funds, they can be used as a hedge against inflation. Due to their volatility, they should not receive a large percentage of your portfolio. Sector funds that invest in specific industries are subject to almost the same volatility as individual stocks, since sectors routinely go in and out of fashion, and rise and fall accordingly. There is little reason to use them for retirement investing.

A Long Term Approach

Asset allocation is a long term investment approach. It does not promote short-term, speculative gains; nor should you aim for such gains with your retirement portfolio.

By following a sound asset allocation strategy, you should be able to avoid wrenching fluctuations of your portfolio’s value, and to grow your portfolio more safely than you would by trying to outguess the market.

In short, asset allocation is an ideal way to “get rich slowly.”

2 Comments on “Retirement Investing Basics: Asset Allocation”

  • Retirement Investing Basics: Asset Allocation…

    Precious metal funds often move in the opposite direction from inflation expectations. Like inflation protected funds, they can be used as a hedge against inflation. Due to their volatility, they should not receive a large percentage of ……

    Posted by Conspirama on October 21, 2008 at 7:42 pm
  • […] fund for reliable income; and a broad-based index stock fund for growth. The only open question is asset allocation among these tried-and-true investment vehicles. The sooner you’ll need the money, the more […]

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