Asset Allocation

Asset allocation is a plan to invest in different types of securities (stocks, bonds, and money market funds) so that the capital invested is protected against adverse factors in the market. This, in essence, is the opposite of an investor putting all his or her eggs in one basket. Diversification is the other balancing tool in a portfolio. For example, a portfolio might have investments in different asset classes according to a well-balanced asset allocation plan, but all the stocks and bonds might be invested in companies in the same economic sector, which would not insulate the portfolio from the risk of loss. By investing in the stocks of different companies in various sectors of the economy and different types of bonds, the portfolio would be better insulated against the risk of loss. The risk of loss has been spread over a number of securities. Increasing the number of stocks and bonds held in a portfolio decreases the volatility. However, by increasing the number of stocks and bonds held in a portfolio, investors are also reducing the potential performance of that portfolio. Diversification seeks a balance between the risk/return tradeoff. The return on a portfolio depends on the types of investments held in the portfolio.

Classifying some of the different types of investments on a continuum of risk, common stocks are considered to be the most risky (in terms of variability in share price), followed by long-term bonds, with the shorter maturities on the low-risk end. Bear in mind that there are many other types of investments that are riskier than common stocks, such as commodities and futures contracts. Similarly, there is a great variation in quality among common stocks. The common stocks of the well-established blue-chip companies are considered to be less risky than the bonds of highly leveraged companies with suspect balance sheets.

Common stocks are considered to be the most risky owing to the volatility of stock prices. However, over long periods of time where the ups and downs of the stock market can be averaged out, stocks have provided higher returns. Common stocks provide the growth in a portfolio and should be included among the investment assets to accomplish long-term growth goals. The percentage allocated to common stocks depends on the investor’s objectives and personal characteristics. As mentioned earlier, a retired widow who depends on the income generated from the investments in the portfolio may not have any common stocks in the portfolio. However, if the portfolio generates more than a sufficient level of income for the widow’s current needs, a small portion of the portfolio could be invested in common stocks to provide some growth in the portfolio for later years.

There isn’t a rigid formula for asset allocation. Rather, it is a good idea to think about the concept as a guideline when investing money. Some investors may tilt toward an aggressive portfolio, whereas others require a conservative portfolio. The mix of investment assets depends primarily on the levels of risk that investors are willing to take and their time horizons. The percentage allocated to the different types of assets always can be changed depending on circumstances. As individual circumstances change, so will the investor’s objectives. If the emphasis shifts, for example, to greater income generation and preservation of capital from capital growth, the percentage of the investments in the portfolio can be changed accordingly. The most important aspect of investing is having an asset allocation plan that signifies the broad mix of assets to strive for. Once these broad categories are determined, the individual assets are purchased. When considering the different types of securities to choose for a portfolio, investors should weigh the characteristics of the types of investments along with the risks to assist them in their overall choice.

Investors need to revisit their asset allocation mix from time to time to determine whether to rebalance their mix and realign it with their investment objectives. The frequency with which the asset allocation plan is rebalanced also depends on the investor’s portfolio management investment style. A passive investment style suggests leaving the portfolio alone, in other words, buying and holding the investments without regard for factors that affect them. An active portfolio investment style involves changing the investment assets within the portfolio whenever external circumstances have the potential to influence performance. The management of bond portfolios is very different from the management of stock portfolios. Bonds provide regular flows of income and have fixed lives, whereas stocks do not mature, might not provide regular flows of income if they do not pay dividends, and do not have maturity dates, which means uncertainty with regard to future stock prices. This means that in the management of stock portfolios there is a greater emphasis on stock selection (buying stocks that will appreciate the most).

Table 18–1 illustrates the need for rebalancing a portfolio. If the investor’s objectives and personal characteristics have not changed one year later, the asset allocation mix should be realigned to the original mix. Both advantages and disadvantages arise from rebalancing a portfolio. The advantages are
* The relative weighting of the portfolio assets are aligned with the individual’s objectives, personal characteristics, risk tolerance, and rate of return.
* The risk of loss is reduced by selling appreciated assets to realize capital gains.
The disadvantages of rebalancing a portfolio are
* Rebalancing a portfolio incurs trading costs (commissions) and advisory fees.
* Investors run the potential risk of loss that comes from selling the winners in the portfolio to buy more of the losing assets.
* Selling securities involves tax implications in taxable accounts.

Table 18-1
Rebalancing a Portfolio
1. Begin with an asset allocation plan.
The investor started with the asset allocation illustrated in Figure 18–1.
2. Revisit the asset allocation plan after a period of time.
One year later with the rapid appreciation of the equity portfolio, the asset allocation mix has changed to the percentages shown in Figure 18–2.
3. If necessary, rebalance the portfolio.
The investor needs to determine whether this new asset allocation mix is consistent with his or her objectives, personal circumstances, and risk tolerance. With appreciation of the equity assets, the new equity mix is now 50 percent of the total portfolio value, and the bond mix has dropped from 50 percent to 35 percent. This may not be suitable for an investor who relies more on incomegenerating assets than on growth assets. Rebalancing requires selling off some stocks and buying more bonds with the proceeds in order to realign the asset allocation mix closer to an acceptable asset allocation mix.
4. Proposed asset allocation plan after rebalancing.
Figure 18–3 shows the current and proposed asset allocation mixes.



Figure 18-1. Original Asset Allocation Mix


Figure 18-2. Asset Allocation Mix One Year Later


Figure 18-3. Current and Proposed Asset Allocation Mixes


The most important aspect of investing is having an asset allocation plan that signifies the broad mix of assets to strive for. Once these broad categories are determined, the individual assets are purchased. Table 18–2 presents examples of different asset allocation plans for investors with different investment objectives.

Table 18-2
Asset Allocation Models for Different Investment Objectives
A conservative portfolio is one in which the investment goals are to preserve capital, allowing for some growth to the portfolio. The weighting is geared toward high-quality bonds and some common stocks for growth. See Figure 18–4.
A balanced portfolio includes a larger percentage allocated to common stocks, which provide capital growth for the portfolio, and another large percentage of fixed-income securities, which provide the income for the portfolio. See Figure 18–5.
An aggressive portfolio is overweighted in common stocks in order to provide capital growth without any regard for generating income for the portfolio. See Figure 18–6.
The allocation plan of a young couple, both professionals who are not dependent on income from their investments and are investing for long-term growth, could break down their stock investments into the categories shown in Figure 18–7. This is a second example of an aggressive portfolio allocation.

Figure 18-4. Asset Allocation for a Conservative Investor


Figure 18-5. Asset Allocation for a Balanced Portfolio


Figure 18-6. Asset Allocation for an Aggressive Portfolio


Figure 18-7. Stock Portfolio Allocation for a Couple Seeking Long-Term Growth

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