Picking stocks may be more fun than divining "asset allocation," the percentage of stocks, bonds and other types of investments that you own, but studies show that a balanced portfolio can have a bigger impact on long-term performance than individual stock picking.
The good news: if you follow a few basic rules, asset allocation can be smoother and less time consuming than scouring for the next Apple or Google.
Consider your goals. Knowing when you will need the money how much and how soon should help you get started.
- Time cures. When you're saving for a long-term goal, time can smooth the returns of volatile investments. Volatility, which refers to the swings of an asset, is great when your holdings are going up and scary on the way down. A long-term perspective helps when you own more volatile assets, such as small-cap stocks or commodities.
- Except when it doesn't. If you're saving for a short-term goal, like a teenager's college education, risky, volatile investments may work against you, plummeting right before you need the money.
- Watch out for inflation. Retirees or anyone living on a fixed income needs to worry about the damage that inflation can inflict on both buying power and regular payments, from bonds, for example, or annuities. Owning commodities, Treasury Inflation Protected Securities (TIPS), as well as a healthy dose of stocks, can help moderate inflation.
Be honest about your risk tolerance.
- Investing involves risk. All investments involve some risk, even seemingly "safe" investments like blue chip stocks or Treasury bonds. If you need some money for a short-term goal and you cannot afford to lose a penny of it, put it into an FDIC-insured product such as a savings account or a certificate of deposit.
- No pain, no gain. Riskier assets such as small-cap or emerging markets stocks tend to have greater returns over time, but can also have violent swings. For example in 2008, emerging market stocks fell 53% percent and clocked in at 79% gain in 2009.
- The rule abides. You may have heard one of several adages about how to mitigate risk in an investment portfolio. They all amount to a quick fix for determining how much of your portfolio to hold in less risky assets, bonds for the most part. Some say to hold your age in bonds (40 years old = 40% bonds); other say 125 less your age in stocks (85=85% in stocks.) As you can see from this example, some rules of thumb are too far apart to even wrestle. The lesson here, though, is to have some starting point for dividing your riskiest holdings (stocks) from your less risky (bonds). You can view the historical returns of stock/bond splits here.
Go beyond stocks and bonds.
- Invest in more asset types. One way to reduce the volatility of a portfolio is to add some alternative assets like commodities or real estate, which don't generally track the markets for stocks and bonds. Commodities can also counteract inflation, because their prices typically rise when inflation picks up. If you're risk averse then consider putting a small portion of your portfolio in a market-neutral fund, which aims to make a profit in both bull and bear markets.
- Know what you own. Just because their values aren't updated quarterly in your brokerage statement doesn't mean that collectibles, houses, art and other valuables aren't actually part of your investment portfolio. While such items aren't often quickly sold, they do have value and risk to consider before you expand your holdings in other directions.
What not to do when putting together an investment portfolio. Many investors make one or more of these common asset allocation mistakes:
- Don't follow fads. Focusing on fads can get you in trouble. Chances are an investment fad has already produced high returns before you heard about.
- Don't be satisfied. Taking the "set-it-and-forget-it" mentality too far can be costly. If you don't review your portfolio regularly (annually, quarterly or monthly, just decide) then you could wind up with an asset allocation that is vastly different from what you set out with.
- Don't lose money. It can take years to make up for a huge setback in your portfolio, so don't ignore assets that hold up in all markets such as dividend-paying stocks, short-term bonds or cash.
For more reading: The Securities and Exchange Commission has an in-depth guide to asset allocation for folks who are just getting started. SmartMoney's Perfect Portfolios give you a running start on determining the right asset allocation for your age. Our asset allocation tools for workers and retirees can also serve as a starting point.