| Choosing an asset allocation, or the mix of stocks, | | | | the value of global equity markets, and investors |
| bonds and cash in a portfolio, is the most | | | | have historically been compensated for the risks |
| important decision that you'll face as an investor. | | | | that accompany international investing. Likewise, |
| A study by Ibbotson Associates concluded that | | | | REITs offer a great diversification benefit and |
| asset allocation decisions determine about 100 | | | | give investors unique exposure to the commercial |
| percent of investment performance for those | | | | real estate market. |
| who follow a low-cost, long-term investing | | | | Within your US and international stock allocation, |
| strategy. Similarly, according to a Dalbar and | | | | you may also want to boost your exposure to |
| Associates study, many investors underperform | | | | small company and value investments, as |
| the market because they deviate from their | | | | investors have historically been compensated for |
| asset allocation plan during market downturns. | | | | the risks inherent in these investing styles. If |
| Investors who want to maximize their long-term | | | | you're not familiar with the arguments for |
| investment returns must develop a | | | | overweighting these equity segments, however, |
| risk-appropriate asset allocation plan that they can | | | | you should probably steer clear of them in favor |
| stick with in good times and bad. | | | | of simplicity. |
| Asset Allocation Step 1: Evaluate Your Risk Profile | | | | To expand your fixed income allocation beyond a |
| A reliable, long-term asset allocation plan starts | | | | broad sampling of the US Bond Market, consider |
| with a thorough understanding of your risk profile. | | | | adding Treasury Inflation-Protected Securities |
| It's helpful to think of your risk profile in two | | | | (TIPS) and municipal bonds. TIPS are unique |
| parts: your risk capacity, or the degree of | | | | because, unlike traditional bonds, their principal and |
| portfolio volatility that you can absorb financially, | | | | interest payments adjust with inflation, so they |
| and your risk attitude, or your emotional tolerance | | | | offer a government-guaranteed rate of return |
| for risk. | | | | above inflation when held to maturity. Municipal |
| Risk capacity is influenced by factors like income | | | | bonds are appropriate for investors in high tax |
| and net worth, but its largest determinant is time | | | | brackets with taxable investment accounts, as |
| horizon. Early in life, when retirement is far off, | | | | the interest from these bonds is generally |
| your future earning potential can be thought of as | | | | tax-exempt in the issuing state and at the federal |
| a sizable bond, allowing you to allocate the | | | | level. |
| majority of your retirement portfolio to more | | | | Portfolios can be sliced and diced in any number |
| volatile equity investments. As you grow older | | | | of ways, but a more complex portfolio is not |
| and your future earning potential decreases, it's | | | | necessarily a better one. Wise investors |
| important to replace those bond-like expected | | | | understand that their investing success will largely |
| earnings with a higher percentage of bonds in | | | | be determined by their ability to stick with their |
| your portfolio. By the time you retire, most of | | | | asset allocation plan, and for that reason, they err |
| your investments should be in bonds in order to | | | | on the side of simplicity. |
| provide a reliable, low-volatility source of income. | | | | Asset Allocation Step 3: Implement Your Plan |
| Risk attitude is more difficult to quantify than risk | | | | Once you've broken down your portfolio into |
| capacity, especially for first-time investors who | | | | target percentages, all that remains is to |
| haven't experienced difficult market conditions. | | | | implement your asset allocation plan. With literally |
| Many investors make the mistake of failing to | | | | thousands of funds to choose from, it's best to |
| understand their risk attitude until a market | | | | narrow down the field by focusing on one factor |
| downturn occurs. This usually leads to selling | | | | that you can control: investing costs. |
| equity investments at the worst time (the | | | | First, you can minimize the impact of many fees, |
| bottom of the market), only to miss out on a | | | | expenses and taxes by investing in low-cost index |
| subsequent market rebound. To help avoid this | | | | funds and ETFs. If your workplace retirement |
| phenomenon, investors can use resources like risk | | | | account has limited choices, simply pick the lowest |
| questionnaires and historical performance charts | | | | cost funds that fill a position in your asset |
| to help find a stock/bond mix with an emotionally | | | | allocation plan. Secondly, pay close attention to all |
| acceptable level of volatility. These tools are far | | | | applicable fees and commissions prior to doing |
| from perfect, however, so when in doubt, it's | | | | business with a brokerage firm or mutual fund |
| best to err on the side of conservatism. | | | | company. IRAs and other investment accounts |
| Generally speaking, your most conservative risk | | | | are extremely portable, so there's no good |
| dimension (capacity or attitude) should determine | | | | reason to stick with a high-commission broker. |
| your portfolio's equity/bond split. For example, if | | | | Finally, maximize your portfolio's after-tax returns |
| you have the risk capacity to handle a portfolio of | | | | by placing tax-inefficient asset classes (e.g., REITs, |
| 80% equities, but can only stomach the volatility | | | | Bonds) in tax-sheltered accounts. |
| of a 70% equity portfolio, you should choose the | | | | Once you've settled on specific investment |
| more conservative allocation. Developing a plan | | | | choices, help yourself stay on track by formally |
| that you can stick with in good times and bad is | | | | documenting your asset allocation plan in an |
| much more important than maximizing your | | | | Investment Policy Statement (IPS). This |
| expected return. | | | | document provides an organized framework for |
| Asset Allocation Step 2: Break Down Equities and | | | | recording your investing goals, philosophy and |
| Bonds | | | | target allocation so that you can help yourself |
| Once you've settled on a risk-appropriate stock | | | | resist the temptation to stray from your |
| bond mix, you can think about subdividing the | | | | long-term strategy. The ideal time to draft an IPS |
| equity and fixed income portions of your portfolio. | | | | is while the rationale for your asset allocation |
| The key to this part of the asset allocation | | | | decision is fresh in your mind. |
| process is finding a suitable tradeoff between | | | | Conclusion |
| simplicity and maximum expected return. | | | | More than any other factor, your ability to |
| Modern Portfolio Theory tells us that by adding | | | | develop and implement a risk-appropriate asset |
| volatile asset classes that don't move in lockstep | | | | allocation plan will determine your investing |
| with the rest of our investments, we can | | | | success. By thoroughly evaluating your investing |
| increase our portfolio's risk-adjusted return. Based | | | | risk profile, choosing an appropriate level of |
| on that principle, consider adding international | | | | portfolio complexity, and picking low-cost |
| stocks and Real Estate Investment Trusts | | | | investments, you've taken a giant step toward |
| (REITs) to your equity portfolio. Companies | | | | your long-term investment goals. |
| outside of the US represent more than half of | | | | |