Risk Tolerance and Asset Models

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.

 

Asset Allocation

Think of asset allocation as a way of reducing your risk by not putting all your eggs in one basket.  Imagine if you put your entire nest egg in a single stock like Enron.  When that one stock plummets, you lose nearly everything.  More generally, think what might have happened if you owned nothing but Technology stocks at the end of the bubble.  This time you may have owned dozens of stock, but you likely lost a substantial portion of your investments.  Asset allocation is a way to spread risk by not putting money in only one kind of investment.  You invest in different asset classes.  This could mean buying stocks of companies that are different sizes, industries and countries, while also putting money into bonds, money markets and even real estate.

 

The idea is that asset classes come in and out of favor at different times.  By rebalancing on a periodic basis, you shift money from classes just in favor to classes that were recently out of favor.  In a sense, by doing this regularly, you are buying low and selling high. All the while you are minimizing your risk.