One of the keys to effective asset allocation for your investments is to determine your risk tolerance. Many web sites offer tools to help you do this. They’ll ask questions about what is the largest loss you would be willing to bear in any single year in hopes of better long term returns. Based on your answers to a series of questions they will recommend different allocation models. A couple hypothetical allocation models are provided below:
Conservative Portfolio: 20% in stocks (15% large cap, 5% international), 50% in bonds, 30% in cash. From 1970 – 2005 this portfolio would have delivered an 8.6% average annual return. Its best year would produce a 22% gain and its worst would be a 0.1% gain.
Moderate Portfolio: 60% in stocks (35% large cap, 10% small cap, 15% international), 30% in bonds, 5% in cash. From 1970 – 2005 this portfolio would have delivered a 10.5% average annual return. Its best year would produce a 30.9% gain and its worst would be a 12.9% loss.
Aggressive Portfolio: 95% in stocks (50% large cap, 20% small cap, 25% international), 0% in bonds, 5% in cash. From 1970 – 2005 this portfolio would have delivered an 11.2% average annual return. Its best year would produce a 39.9% gain and its worst would be a 23.8% loss.
As you can see, you can greatly vary your investing experience simply by your choice of asset classes. Once you’ve diversified based on asset class, you can further manage risk and target returns through your allocation within an asset class. This may mean targeting certain industires like technologies or utilities or investing in funds targeting a certain geography such as South America or the Asian Pacific.
One of the most critical aspects is to evaluate the mutual fund managers. You want to avoid the one hit wonders and those don’t invest in the funds they manage. Consistency and commitment to their fund is an important aspect in picking a fund manager. You want to find the managers that will consistently outperform and have a strong commitment to the fund through their own investment.
