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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 actively involved.

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 you.

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 inflation rate.

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 active funds.

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 you defined.

Next: Learning to Rebalance your assets to reduce risk
Page last modified 3/21/2012