In constructing an investment portfolio, it is tempting to run ahead and start picking out the stocks that you believe will go to the moon. In reality, selecting individual securities or funds to purchase should be one of the last steps. First things first: pay careful attention to asset allocation and diversification before you start stuffing the portfolio with tech stocks and hedge funds. This week we consider the crucial role of asset allocation, the broad classification of investment types appropriate to a well-constructed investment plan.
Christopher A. HopkinsThe first step in determining the proper asset allocation is to understand the various asset classes. We typically break these down into three primary buckets relevant to a basic portfolio: stocks, bonds and cash. Although many other classes of assets exist, they generally come into play later on as your total assets grow. These other classes might include real estate, artwork, precious metals and so on that you may choose to add as your net worth increases. At the outset, let's focus on the basic three.
Stocks (also called equity) represent ownership in publicly traded companies. Over the long term, stocks will tend to be the riskiest of the three asset classes, as their values serve as proxies for the worth of a company. Fortunes of firms rise and fall, as do their stocks, but equities have generally provided the greatest investment returns over time.
While stocks represent ownership of companies, bonds are forms of loans. Just like your mortgage or car loan, bonds carry a stated maturity date on which the principal value is to be repaid, as well as interest payments along the way. High rated (investment grade) bonds are less risky than stocks, and often provide protection for a portfolio when stocks are declining.
Cash is the place to keep your short-term savings necessary to pay the bills, cover emergencies and provide a bullet-proof cushion of safety. Cash (and cash equivalents like insured CDs) provide very low returns but contribute essentially zero risk.
The $64 dollar question: how much to stash in each bucket? As you might expect, it depends. It depends first of all upon your age. Young people just getting started as investors have a very long time horizon over which their savings can compound, and over which the inevitable market crashes can be offset and supplanted by the more prevalent periods of growth. 20- or 30-somethings should plow the majority of their funds (70 to 90 percent) into stocks and ride the wave.
If you are pulling into Retirement Station or rounding the turn into the home stretch, you should limit your exposure to stocks. Recovery time from bear markets becomes more of an issue once you need to protect the capital you have allotted for retirement, arguing for greater weighting toward bonds for risk reduction and income generation. Similarly for cash, as any certain expenses you are expecting over the next year or two should be provided for without any investment risk.
Besides your age or time to retirement, asset allocation depends upon your personal level of comfort with risk. Some investors are very sanguine with a greater exposure to stocks than their age might suggest. Striking a balance is as much art as science; but the correct mix will allow you to sleep at night.
There are a number of excellent asset allocation worksheets and calculators on the internet. Most of the big mutual fund companies and brokerage firms offer tools to assist in choosing the appropriate mix of stocks, bonds and cash for your specific situation. Only then can you profitably begin the construction of a solid portfolio.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.