As we all know, in some years, bonds as a whole, perform better than stocks. Similarly, in some periods, stocks fare better than bonds. In still other
years, investors may do well to stay largely in cash – or in alternative investments or in real estate.
The difficulty, of course, is predicting how any particular asset class will perform in any given year. For that reason, many investors – both institutional and individuals – place their funds in a number of different asset classes, in varying proportions. By definition, then, asset allocation is unlikely to generate the greatest returns – since not all of the investment classes will do equally well. By that same reasoning, however, an appropriately allocated investment portfolio should also protect investors against excessive exposure to poorly performing asset classes and limit volatility.
Defining Asset Allocation
Asset allocation generally refers to broad categories of securities deployed in different combinations and weights to construct the portfolio most appropriate to an investor’s needs and constraints. Commonly used asset classes include, but are not limited to:
| U.S. Equities
| Non-U.S. Equities
| Fixed Income
| Real Estate
| Alternative Investments
| Cash
Within each of these asset classes, diversification provides an additional strategy for controlling risk. For example, rather than investing in one or two individual domestic stocks, the U.S. equity portion of your portfolio might consist of an array of equities. These stocks would probably be diversified by characteristics such as sector, size, geographic location and the outlook for each underlying company.
Similarly, the fixed income portion of your portfolio might be diversified by selecting different types of bonds. Some options could include investment-grade corporate bonds with differing maturity dates or, if you’re willing to accept more risk in exchange for the opportunity to secure a larger income stream, high-yield bonds. U.S. Treasuries provide yet another option. If you could use income that’s exempt from federal – and perhaps state and local taxes – you might want to diversify further into municipal bonds.
Allocating Your Assets
Your asset allocation should be based on your investment objectives and time horizon, as well as on your willingness – and ability – to assume risk.
Discussing your total financial picture – including securities in other accounts, real property, collectibles and other assets – with your financial advisor when developing or reassessing your investment strategy is essential. For example, in developing your portfolio, you may want to stay away from real estate invest- ment trusts (REITs) – no matter how well you think they will fare in the coming years – if you already own two homes and an apartment building. Instead, you may want to balance your real estate holdings with other types of investments – perhaps in assets that historically tended to maintain or increase their values when real estate prices decline. Should real estate prices soar, your existing properties will likely continue to appreciate, while other asset classes, emerging market stocks and U.S. corporate bonds, for example, may not fare as well. However, if real estate prices decline, the idea is that relative strength in these other asset classes should buffer your losses.
Similarly, if you are thinking about structuring an income-oriented portfolio, be sure to consider your other holdings. For example, if you have
$200,000 in bonds held in another account, you risk “overweighting” your total investable assets with fixed income if your new portfolio is heavily weighted in bonds. Depending on your circumstances and your needs, that emphasis on fixed income may be perfectly appropriate – or you may find that you need a greater focus on growth.
Once you and your financial advisor have developed and implemented your asset allocation, the task of managing your portfolio has only just begun. Regularly reviewing your holdings and rebalancing your portfolio to adjust for changes in the market environment or in the performance of your specific securities is essential to meeting your long-term goals.
Similarly, if you are considering a change in your longterm goals – or if they have already changed – make sure that you and your financial advisor restructure your investment portfolio as necessary and reassess your assets so they are aligned with your new objectives.
Assessing Your Portfolio’s True Composition
Understanding the various pieces that make up your portfolio is also key to an effective strategy. For example, you may think your portfolio is in good shape because it’s invested in a variety of mutual funds with differing objectives. Perhaps you own a mutual fund invested in growth stocks, plus a “balanced fund” (typically split between stocks and bonds), as well as some funds that are based on “value investing” and another focused on the technology sector.
To truly understand your portfolio, you and your financial advisor must know how each of those assets relate to and affect each other. Your advisor can help you look at those investments from the inside out – perhaps to discover that, based on your objectives, your portfolio is focused too heavily on growth when you consider not just the growth-oriented mutual funds, but the growth portion of your balanced fund, as well as some of the stocks held in your technology fund. In fact, you may find you own much more of a given type of investment – or even a specific stock – than would
be evident from a quick glance at your portfolio.
A Word on Risk
When it comes to the financial markets, risk has many dimensions. Some type of risk is inherent in virtually every investment decision – even if that
decision is to do nothing.
Thus, if you invest too heavily in traditionally conservative, less risky investments, you may be sacrificing the growth and/or the level of income you need to support the way you live your life. If you move to the opposite end of the spectrum and invest heavily in higher-yielding and, thus, possibly more speculative assets, you may face more risk than you can comfortably assume.
Similarly, if your portfolio is allocated relatively heavily to volatile investments, you’re likely to experience a broader range of price swings than had you invested primarily in more stable assets. Although those volatile investments may have more potential for appreciation over the long term, should you suddenly need to sell them, you may run a greater risk of loss.
However, the greatest risk you assume is the risk of not achieving your overall investment objectives – from buying a new home in two years to generating enough income for your retirement years; from ensuring adequate cash flow to meet your needs and obligations to financing a special needs trust for a family member who may require help down the road.
Thus, assessing your full financial situation, identifying reasonable risks, determining appropriate time frames and setting realistic goals are all essential to the success of your investment strategy.
Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds before investing. The prospectus contains this and other information about mutual funds. The prospectus is available from your financial advisor and should be read carefully before investing.
There is no assurance that any investment strategy will be successful. Investing involves risk and investors may incur a profit or a loss. Asset allocation and diversification do not ensure a profit or protect against a loss.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. High-yield bonds are not suitable for all investors. The risk of default may increase due to changes in the issuer’s credit quality. Price changes may occur due to changes in interest
rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of your portfolio. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. In addition, certain municipal
bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax.
U.S. Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. Treasury bills are certificates reflecting short-term obligations of the U.S. government.
Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum-net-worth tests.
Specific-sector investing, such as real estate, can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
International investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing in growth stocks generally involves greater risks, and therefore, may not be appropriate for every investor.
Written by Raymond James Financial Services, Inc.
Bountiful, UT 84010