Asset Allocation: The Key to Long-Term Investment Performance

The downturns in the stock market and the collapse of several corporate giants have many investors concerned about the safety of their investments. Although there are no guarantees when it comes to investing, the California Society of CPAs (www.calcpa.org) says smart asset allocation can help protect your portfolio.

It’s All in the Mix
Asset allocation refers to the percentage of your portfolio dollars invested in the different investment classes—stocks, bonds, and cash equivalents, such as money market funds and short-term certificates of deposit. Simply put, an effective asset allocation will discourage you from putting all your eggs in one investment basket.

But don’t let the simplicity of the concept undermine its importance. Many studies have shown that asset allocation is the single most critical determinant of long-term investment performance. It is more likely to impact your overall investment success than the process of choosing the actual stocks, bonds, and funds to buy.

The rationale behind asset allocation is relatively easy to understand. Not all investment classes of assets move up and down at the same time and rate. In some years, stocks generate the best returns, while in others, the bond market is the place to be. There even have been periods, albeit few, when a bank certificate of deposit was the investment vehicle of choice.

It’s Driven By Life Circumstances
Perhaps the first thing you need to know about asset allocation is that there is no one mix that is right all the time. For example, an allocation of 80 percent stocks and 20 percent bonds that worked well for you in your prime earning years may be totally inappropriate as you enter retirement. Similarly, the allocation that best suits your neighbor whose tolerance for risk is reflected in his career as a stunt car driver may cause you many a sleepless night.

Your investment goals, timeframe and tolerance for risk all figure into choosing an asset allocation that is right for you. Common investment goals include saving for a new, larger, or second home, a child’s education, and a secure retirement. Your investment time horizon—the number of years before you will need the money to fulfill your financial goal—is another important factor. The further off your investment goal is, the more aggressively you can invest, since you have more time to weather the market’s swings. As your investment horizon grows closer, your investment strategy should gradually become more conservative, shifting the focus from capital growth to capital preservation.

Finally, your tolerance for risk represents your ability and willingness to grin and bear declines in the value of your investments.

It’s Not Just A One-Time Event
The next step calls for you to review your current investments and determine how much of your portfolio is invested in each of the asset classes. As you do this, be sure to consider not only the assets in your personal investment portfolio but also those in a 401(k), IRA and other retirement vehicles.

As you sift through the holdings in your portfolio, it’s a good idea to keep diversification in mind. You want to be sure that your portfolio isn’t dominated by one stock or sector. For example, within your stock class, you will want to diversify among different industries, large and small companies, and domestic and international companies.

It’s important to think of asset allocation not as an event, but as an ongoing process. That’s because the distribution of assets in your portfolio is likely to fluctuate along with the market. A run-up in the stock market could see your 70 percent stock and 30 percent bond allocation become 85 percent stock and 15 percent bond. You should check your asset allocation at least once a year and rebalance as necessary.

If you need help formulating an asset allocation plan that aligns with your goals, investment horizon and risk tolerance, consult with a CPA who specializes in financial planning.