Asset Allocation
 |
|
|
Regardless of the type of qualified or non-qualified plan you are in, asset allocation will be one of the most important decisions you make to optimize the return on your investments and reduce risk. Assets for purposes of this discussion will be limited to stocks, bonds and cash( money market funds ). Stocks are considered to have more risk than bonds. Some stocks are riskier than others. The greater the risk, the higher the expected return, accompanied by greater volatility in the price movement of the stock. The allocation of stocks and bonds in your portfolio should be determined by your tolerance for risk and the time horizon for your need to draw funds from the portfolio.
Stocks represent ownership in companies of different industries (automotive, banks, technology, real estate, oil, etc.).Therefore, a further allocation decision is necessary as to which industries should be included in your portfolio, and why.
The following 7 paragraphs illustrate the asset allocation process.
|
1. In a perfect world It would be simple if the market value of a stock mirrored its underlying book value. For example, if the book value of Stock A, a large, stable, well financed company, was $10.00, the stock would sell in the marketplace for $10.00. If it's selling price increased at the same rate as the growth of its book value, a 10 year chart of Stock A growing at 10% would look like figure 1. |
|
|
2. The marketplace is an auction The marketplace is an auction however, and the price of Stock A is determined by bidders who over value or under value it at a given time, based on external factors, such as interest rates, recession etc. See figure 2. |
|
|
3. Low correlation While Stock A is being overvalued, Stock B, with similar characteristics but in another industry, is being undervalued because of the same external factors see figure 3. These stocks are said to have a negative or low correlation. |
|
|
4. High correlation The stocks in industries that go up and down in value at the same time are said to have a positive or high correlation. A high correlation of assets will result in all your assets moving up and down at the same time. See figure 4. |
|
|
5. The effect of riskier stocks The riskier the stock, the wider the price swings from the mean. These stocks, however, are expected to
have a higher rate of return as a tradeoff for more volatility. |
|
|
6. The effect of bonds Bonds are pretty much a reflection of interest rates. Although interest rates change, the changes are usually not abrupt nor major in scope. Bonds are therefore used as a damper on volatility. |
|
|
7. Summary In summary, an asset allocation portfolio can be structured, utilizing a mixture of assets, that will
achieve the desired rate of return, while diversifying away excess risk. This is known as achieving a risk
adjusted rate of return. |
|