Asset allocation is a critical component of investing success . Both research and academic studies show asset allocation to most important factor in determining your financial goals . Allocation affects both the overall long-term risk and return of your investment portfolio . Other factors such as security selection and market timing accounts for a very small percentage of your investment returns. Unfortunately , the most important decision for achieving financial success is also the least understood .
What is asset allocation ? Most people confuse asset allocation and diversification . They believe that similar assets has something to do with making multiple investments between groups. Ask investors to list the assets which they would consider investing . Typical answers include " growth stocks " , " bonds" , " large caps " and sometimes " international equities . " But their distribution is limited to selection within an asset . For example , a person can opt for technology stocks to buy invest in five or six companies - but all within the technology industry . This reduces risk as one of the companies would fail, but is useless when the technology industry (or the entire stock ) slumps.
Asset allocation continues diversification to limit all types of financial assets ( cash , stocks, bonds , commodities, real estate and even venture capital or hedge funds ) . Risk Investments and risks can be further divided into sub-classes of shares, including large-cap , mid - cap , small - cap , value versus growth and international versus domestic . Similarly, bonds are divided into subcategories of short-term and long-term , tax - free , high yield , convertible, emerging markets , floating rate , and international versus domestic . Several combinations allows investors to allocate their portfolios in a number of asset classes and categories .
Adding a high-risk asset classes and investments for a portfolio may seem risky. But the combination of assets that behave differently , or even opposed, both increases efficiency and reduces the risk of an entire portfolio. Thus, international stocks considered ' riskier ' than domestic stocks Yet we often see the prices of U.S. stocks rise on the same day the prices of international equities go down - . And vice versa We call this negative correlation Gains from one asset. . balance the losses of another. a combination of international and U.S. equities actually reduces investment risk by reducing the daily price fluctuations of our entire portfolio .
History shows many markets exhibit similar negative price correlation . In a collapsing economy , strong performance bonds than stocks when interest rates drop . In an overheating of the economy, inflation helps generate stellar returns in the commodities market . But the timing of such events is unpredictable , and the variability of returns is risk for an investor . Choose only stocks, but bonds , or a single asset class to buy increases the risk to lose if the market underperforms money.
The strength of the asset allocation comes from reducing risk while increasing efficiency. Reducing risks by combining , however , multiple asset classes is not a simple process . While each has its own unique active measure of risk , many assets share the same pricing behavior ( their prices go up and down together in each market ) . Combine like free investments increase the risk of wild changes in price. Trade - offs between active risk and expected return should also be taken into account . High-yielding assets typically experience high volatility or material change in the price. These assets must be offset by protecting against large declines in value . Investments with lower returns
Successful asset allocation requires finding the right mix of assets to reward it with a level of risk acceptable balance. Good distribution planning requires research assets and investment analysis. Fortunately, tools are available to help the independent investor . Popular financial websites provides independent investors help with educational software and links to the portfolios based on a survey of financial questions to build . For sophisticated investors , many books written to carefully explain the theory and practice of asset allocation - also called MPT ( Modern Portfolio Theory ) . Casual investors can fund specifically designed to asset allocation based on an expected retirement automate buying . Pragmatic investors can explore the many financial planners and advisory asset allocation portfolios that are specific to their needs to offer.
Carefully consider your options . Each solution has its own set of advantages and disadvantages . Choose a style that closely reflects your own . How important is asset allocation ? It is the biggest determinant of your long term financial success .
Tim Olson
TheAssetAdvisor.com [ http://TheAssetAdvisor.com ] Subscribe to our free newsletter .
Mr. Olson is the editor of The Asset Advisor, a financial investment services proven strategies for no - load mutual fund investors . He brings 26 years of training and experience of the Stanford University , Ernst & Young , personal wealth management , and venture capital investing .
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