Planning Your Asset Allocation
Over time, the asset allocation decisions will be the primary determinant of a portfolio's
volatility/return characteristics. It is therefore essential that the investor be
Roger C Gibson, Asset Allocation
Phase 1: Asset Inventory
The first step in preparing an asset allocation plan is simply figuring out what
it is you already have. Make a list of every retirement account you have, the balances
of each account, and list the investments in each. You may also intentionally leave
out certain accounts or assets, such as an emergency fund or your home, as many
people consider those outside the realm of retirement savings.
By having a single list of your entire retirement portfolio, you can see which areas
you may be overlapping in, whether or not your portfolio reflects your risk tolerance,
and can help you decide whether consolidating accounts can make things easier for
Phase 2: Basic Allocation Plan
The next part of planning your asset allocation is to develop an overall look to
your portfolio. The goal is to find an overall balance between equities, bonds,
and cash-equivalent assets that match your risk tolerance. The idea here is not
to worry about individual stocks or funds, but instead figure out how much of your
portfolio should be each of the asset groups.
For many investors, equities and bonds comprise their entire portfolio, as the risk
of inflation is too great to hold much cash-equivalent assets in a long-term portfolio.
There are many ways to decide what percentage of your portfolio should be bonds,
but a very popular way is also one of the easiest; hold your age in bonds.
Following the age in bonds rule, a 40 year old investor would have 40% of his or
her portfolio in bonds and 60% in equities. The goal of this rule is to slowly create
a more conservative portfolio as the investor reaches retirement age. Some argue
that the "age in bonds" rule is too conservative and opt for 120 minus
your age in stocks, meaning that same 40 year old investor should instead have 120
- 40 = 80% in stocks and 20% in bonds. The ultimate goal of creating a lower risk
portfolio as time moves on is the same in each case, but the breakdown varies.
Whether you chose to be more aggressive and hold 120 minus your age in stocks, follow
the more conservative recommendation of your age in bonds, or create your own interpretation
of allocation, you should now have an idea of what your portfolio should look like
at the end of your planning process.
Phase 3: Choosing Asset Classes
Now that you have an ideal portfolio with a breakdown between equities and bonds,
you can decide how to break down each of those sections into more defined segments.
Stocks are commonly broken down into 2 global areas; the Unites States and everywhere
else. Since diversification seeks to minimize risk by avoiding groups of correlated
assets, investing in the international markets helps avoid investing too heavily
on only the Unites States market. Experts will argue forever on the correct allocation
of your equities holdings that should be international, but a fairly common amount
is 20% of your equities holdings in non-US investments.
There are two main ways that most US stocks are classified. First, the size of the
company is used to group similarly sized companies together. Small, Mid, and Large
caps are used to track small, medium, and large companies. Secondly, companies are
grouped based on how they are expected to perform. There are Value, Balanced, and
Growth companies, which means a company is assessed to be worth more than it the
stock price indicates, the company has a balance between value and growth attributes,
or the company is expected to grow and therefore increase the company's stock
price. Companies that are small tend to be riskier than large companies while value-based
companies tend to be riskier than growth-based companies, so it is important to
diversify across all 9 style profiles, even if one part is weighted heavier than
the others based on your risk tolerance.
The bond section of your portfolio is aimed at growth with little risk. Many individuals
split their bond portion of their portfolio evenly between nominal bonds and inflation-protected
securities. Nominal bonds include government and corporate bonds, each of which
can be further divided into short, intermediate, or long-term groupings. Inflation-protected
securities aim to provide a real return over inflation by basing their rates on
the changes in inflation or tracking assets that are strongly correlated to the
Phase 4: Picking Individual Assets
Now for the exciting part! Pick individual investments to purchase or sell so that
your portfolio closely matches your asset allocation plan. You will want to research
different products for each section. There are many individual stocks, mutual funds,
ETF's, or index funds that meet specific asset class needs. Be sure to compare
the costs associated with each type of investment. Index funds are a strong choice
for any asset class as they minimize costs while outperform most of their competitive
Since you are buying and selling assets, now is a perfect time to also consolidate
accounts or roll over a previous employer's 401k to a rollover IRA so that you
have easier access to all your investments and can more easily track your progress
in the future.
Make sure you keep track of your asset allocation plan as time goes on and rebalance
as needed to ensure your portfolio maintains the risk exposure for your age that
Next: Learning to Rebalance your assets to reduce risk
Page last modified 3/21/2012