Determining the appropriate asset allocation for your investment portfolio is more of an art than a science. And it is the most important decision you will make managing your portfolio — not for rewards, but to control and manage risk.
To help understand the process, here are some terms you should know. Asset allocation is the process of constructing a diversified investment portfolio by combining different assets, such as stocks and bonds, in varying percentages. An asset class is a group of assets with similar characteristics, such as large-cap stocks, small-cap stocks, high-yield bonds and treasury notes.
In addition to market capitalization, stock asset classes can be further classified by investment style — growth, value or blend. Fixed income or bond asset classes can be further classified by length of maturity, taxable or tax-exempt, and domestic or international.
Because a specific asset class has distinct characteristics from other classes, it will not perform exactly as other asset classes when market conditions change. This is good. With varying asset classes, you have the ability to construct a well-diversified portfolio, thereby reducing some risks.
Investing in several different asset classes may reduce overall volatility without sacrificing return. In some cases, it may actually enhance return.
There are many factors to consider when determining your appropriate asset allocation.
* Liquidity needs. What percentage of your portfolio should be invested in cash or cash equivalents to meet short-term capital needs?
* Time horizon. Will you need to access the principal in a relatively short period (three to five years)? If so, a conservatively built portfolio may be appropriate. A time horizon greater than 10 years allows the assumption of more risk by utilizing a combination of riskier assets and a more aggressive investment strategy. History has demonstrated that risk appears to diminish with time.
* Tax considerations. What is your marginal tax rate? Are tax-exempt or taxable fixed income securities most appropriate? How will differing tax rates for dividends, interest and capital gains affect your after-tax total return? What asset classes should you have in your personal (nonqualified) account versus your retirement (qualified) account to take advantage of the different tax rates and income tax deferral?
* Expected returns. What is your expectation of annual total returns (income plus capital appreciation) from these assets? Is 4 percent acceptable, or are you looking for 10 percent? If 10 percent, are you willing to accept the higher level of risk associated with such an expectation?
* Risk tolerance. This is where your decisions become more art than science. The previous factors are straightforward. If answered correctly, a financial adviser would be able to construct a well-diversified portfolio capable of meeting your investment objectives.
However, would you be comfortable with the resulting asset mix if your adviser recommended that 80 percent of your portfolio be invested in stocks? You are the only one who truly knows your risk tolerance. A good financial adviser or portfolio manager will actively listen to you as you articulate your risk tolerance.
The real art of the asset allocation process involves the portfolio manager understanding and validating your risk tolerance and other factors for the sole purpose of constructing a well-diversified portfolio that will meet your investment objectives. It is a balancing act between developing an appropriate asset mix based on an objective approach and a subjective understanding of your risk tolerance and comfort level.
So what is the best asset allocation for you? It is one that you understand, are comfortable with and that will help you meet your investment objectives. But most important, it is one that will allow you to sleep comfortably each night knowing that your assets are working for you within your risk parameters.
Rich Snebold is co-founder of The Family Business Center at Citizens National Bank. The Family Business Center provides business advice and expertise to privately held companies. Reach him at (888) 829-2162, [email protected] or www.familybizcenter.com.
