When was the last time you re-evaluated your personal financial situation? If you haven’t done it lately, now’s a very good time to evaluate your overall plans for the future. The reasons for doing it now are obvious: increasing insurance premiums, a volatile economy and continuing changes in tax laws. Not so obvious are the variety of financial strategies available to help you offset the adverse impact of these factors on the growth of your assets.
One of these strategies is asset allocation, the purpose of which is to establish a portfolio that is diversified among different types of investments. Because different sectors of the market move in different patterns, asset allocation seeks to reduce the risk of major losses and increases the opportunity for solid returns.
Studies have shown that an asset allocation policy is critical to investment success. Keep the following principles in mind:
- Use the 90-10 rule. Ninety percent of investment results depends on your asset allocation decisions; 10 percent is due to selection and timing. Most investors spend 90 percent of their time “timing” and “selecting.”
- Be efficient. Use modern portfolio theory to create the best mix of investments and reduce volatility. Most investors emphasize return or risk avoidance, while efficient portfolios balance both.
- Use time, not timing. Investors tend to buy high and sell low because they “time” their buy-and-sell decisions. Invariably they make the wrong decision. No one can accurately predict the market.
- Think intellectually, act intellectually. It is one thing to develop a sound portfolio and another to stay with it when the markets falter. Most people are motivated by emotion based on short-term variables and the “latest news.” Success in market investing requires patience and stamina. Making short-term moves is generally a prescription for disaster. Most investors have little faith that the markets rebound, so they often sell at the bottom, converting a paper loss to a real loss in the hopes of saving money. You pay a high price for a rosy consensus. By waiting for everyone to agree if it is OK to invest, you are likely to buy at market highs.
- Start early and let compounding do the work. Most people understand the importance of saving but don’t appreciate the impact of starting now. An investor earning 10 percent will grow $100,000 to $1.6 million in 28 years. Waiting 10 years will require $287,000 to achieve the same result! (This is a hypothetical illustration and not indicative of future performance.)
- Know your real rate of return. After taxes and inflation, what are you keeping? Your expected rate of return is an important element in your portfolio design. Develop a system to track your progress at least annually. You can then adjust in a timely fashion. On a $100,000 initial investment, the difference between 7 percent and 10 percent over 28 years is $800,000 ($1.6 million vs. $800,000 using the “rule of 72”). (This is a hypothetical illustration and not indicative of future performance.)
- There is wisdom in saving regularly. Historical data shows that a systematic pattern of investing reduces short-term risk and reduces average share prices (dollar cost averaging).
The percentage of your portfolio that is allocated depends on your risk tolerance and the blend of investment attributes you desire. Asset allocation increases diversification and reduces volatility by investing in a variety of investment funds and investment programs from a variety of managers. (Diversification may help reduce, but cannot eliminate, risk of investment losses.)
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