Thursday, August 7, 2008

Asset allocation - the basics

If you are investing, asset allocation - or how you spread your money between different investments - is the single largest factor that will determine how well your investment does.

Proper asset allocation not only reduces risk, but can actually increase your returns.  The math behind this gets very, very complicated.  (Check it out in this wikipedia entry if you are interested.)  What the math shows is that you can create a diversified portfolio that will have a higher return and the same level of risk as a single (non-diversified) stock.  You could also create a diversified portfolio that has the same expected level of return as the stock but a lower level of risk.  Either one of these portfolios is a better investment than the single stock.

The main building blocks of a large, well diversified investment portfolio are: (listed in order of lowest risk to highest risk)
  • Cash
  • Bonds
  • Large cap stock
  • Small cap stock
  • Foreign stock
This does not mean that everyone needs to invest in every category.  If you are just starting to invest and only have a few hundred or few thousand dollars to work with it is best to chose only one fund.  I would suggest that you start with either a large cap stock fund or a bond fund, depending on your risk tolerance and your time horizon.

If, however, you have larger pool of money it makes sense to spread it between several different asset classes.  

Determining the proper asset allocation for yourself is part math and part psychology.  In order to determine the proper asset allocation for your investments, you should consider your willingness to experience volatility (risk), the length of time you have to invest, and how firm your investment target date is.

If you are interested in looking into the proper asset allocation for your investments, these sites might help:

No comments: