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Asset Allocation

September 18, 2012

Asset allocation is a method of apportioning investments to help accomplish investing goals.  The object is to balance investments so that the overall portfolio growth and cash flow objectives will be attained, consistent with the level of risk willing to be assumed.

 

I recommend asset allocation for long-term portfolios, which should be a minimum of seven years.  This allows for some degree of the market’s inevitable ups and downs to balance themselves.  It also allows compounding to work its wonders.  If your time horizon or needs are for less than about seven years, you should use different criteria as these asset allocation methods will not apply to you.

 

Asset allocation needs to be individually tailored based on each person’s situation.  Asset allocation construction for someone age 40 would be completely different than for someone age 70 with the same amount of funds to invest.  Irrespective of what is suggested, you have to assess your risk tolerance and if you are not comfortable or are insecure with a category, then you should forgo it.  But, should then endeavor to learn more about it so it could be given a fair chance to become part of your portfolio.

 

Asset allocation is about arranging your investments.  It is not about organizing all your assets, although that is never a bad idea.  For that reason, I suggest not including rainy day funds, homes, rental property, businesses, collectibles and other assets that do not generate cash flow, are illiquid or set aside for a specific purpose.  However, to the extent some of these investments are sensitive to inflationary growth, this should be considered in your asset allocation mix with perhaps a greater allocation toward fixed income.  Debt is not part of asset allocation and should be paid down as sensibly as possible before committing funds to a long-term path.

 

I have found that for many people two broad categories are all that is needed with the percentages in 25% increments.  It is simple, much less confusing, and it works.  As portfolios change, the percentages could be refined, adjusted or proportioned.  Too many choices thwart a clear understanding of what you are doing and can hide the true risks.  The two broad categories are stocks and fixed income which are bonds and CDs.

 

Here are five broad allocation choices:

  • all stocks
  • all fixed income
  • 50:50 of each
  • 75% fixed income and 25% stocks
  • 25% fixed income and 75% stocks

 

I do not think it is prudent for most people to completely exclude one of these categories which leaves you exposed to excesses that can occur.  For instance, if all your funds were in bonds and rates dropped significantly on reinvested funds, your cash flow will drop and you would not have any ability for sustainable growth in asset values.  All your funds in stocks indicate a very aggressive posture.  I do not believe this is prudent for long-term financial security.

 

The next choice is 50% of each.  This is a good middle ground for many people.  It provides for half your assets providing a guaranteed cash flow and the other half the ability to grow along with dividend payments.

 

The next choices are for those tending toward either end with a 25:75 division.  75% in stocks represent an aggressive posture, while 25% in stocks indicate a more conservative attitude with a desire for greater guaranteed cash flow with less risk of loss.

 

Asset allocation presents a method of investing that provides balance consistent with your longer term financial goals and risk tolerance.  It is a tool that needs to be considered.

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