Paul Lim - Asset Allocation DeMystified: A Self-Teaching Guide

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Contents

chapter

What Is Asset Allocation?

Ask any pastry chef or baker: What would happen if you gathered together all the best ingredients in the worldvanilla from Madagascar, chocolate from Oaxaca, chir butter from Francebut failed to take the time to mix them together properly? Youd end up with an expensive but decidedly disappointing dessert, right? Ask any construction worker: What would happen if you were to combine water, sand, and cement together, but in incorrect proportions? Youd most likely get a weak batch of concrete, and a potentially dangerous foundation for your structure.

In a nutshell, thats what asset allocation is all about. It is the process by which investors can build a safe, solid foundation for their investment portfolio by making sure not only that they own sound investments, but that those assetsranging from stocks to bonds to cash to real estate to gold and other commoditiesare held in the proper proportion based on their circumstances.

What Defines Proper Asset Allocation?

Should you invest for capital appreciation (a fancy way of saying growth) by loading up on assets that increase in value quickly? For instance, should you keep, say, 75 percent of your money in stocks, with 15 percent in real estate and 10 percent in bonds? Or should your goal be capital preservation (i.e., safety at all costs) by keeping all or most of your money in relatively stable investmentsfor instance, 50 percent of your money in bonds, 25 percent in gold, and 25 percent in cash?

There are a whole host of factors that go into answering this question and establishing what the proper mix of stocks, bonds, real estate, gold, and other assets is for you and your portfolio.

For starters, there are the variables you hear about most often from the personal financial media and the financial services industry: your age and the approximate year in which you intend to retire. In the parlance of personal finance, this is referred to as your time horizon. These factors are indeed quite important. After all, youre investing for a goal, and for most Americans, the biggest goal is likely to be the ability to pay for a long and comfortable retirement in the future.

A Key Fact to Consider: The more time you have before youll need to spend the money youre investing, the more risk you can afford toand shouldtake with your portfolio. Often, that means the greater exposure your portfolio ought to have to stocks, especially fast-growing shares.

This is true not only because a person with a long time horizon can afford to take more investment risk, since he or she would have time to make up for any short-term setbacks the portfolio might suffer early on. Its also because time has a funny way of eroding the value of anyones portfolio through the deleterious force known as inflation, which chips away at the purchasing power of ones money over time. And over extremely long periods of time, the compounding effects of inflation every year can really put a dent in your portfolio ().

Personal Sensibilities

You cannot ignore other variables that are more personalthat speak to who you are as an individual and what your circumstances are now and could be in the future. For instance, how would you describe yourself as an investor? Are you a risk taker by nature, or do you feel more comfortable playing it safe? What is your psychological tolerance for risk? When faced with unexpected bad news, are you likely to double down your resolve and stick to your guns? Or are you much more likely to panic at the earliest signs of bad news?

All of this matters in establishing the right investment strategy for you, because the worst thing you can do is set forth an investment plan early onfor instance, one that requires you to be heavily weighted toward stocks, and not just any equities, but the riskiest types of shares, such as those of a tiny start-upthat you know in your heart of hearts youll ignore or upend down the road when the pressure is on (for instance, should the stock market run into a hiccup or a sustained downturn).