Updated September 9, 2009 Selecting an asset allocation means you are putting your risk profile to work in a way that balances the risk and reward in your overall portfolio. It is also the factor that contributes the most to a portfolio’s return. Read that again. It is also the factor that contributes the most to a portfolio’s return. To illustrate this, think of investing like a funnel:
This funnel is derived from research presented by Ken Fisher in his book, The Only Three Questions That Count. 70% of investment returns come from an investor’s asset allocation and only 10% comes from security selection.
The right asset allocation balances the volatility (i.e. standard deviation or risk) in a portfolio with the expectation of certain returns. My approach is to take on as little risk as possible but enough that will allow me to beat the market returns over time. There is a great deal of research that has been done to identify what these optimal asset allocations are. I use William Bernstein’s work as my primary guide to determine my asset allocation. In addition, I use the work suggested portfolios over at Sound Investing on asset allocation to help. However, I differ slightly from his methods as I do invest in a small portion of individual dividend growth stocks.
Coming up with an asset allocation does not need to be overly complex. An individual can choose to hold as few as 4 asset classes or as many as they want. They key is finding something that you can manage and keep track of. Based on the research from Bernstein and Sound Investing, and my desire to take a very active part in my portfolio, I have determined that my target asset allocation is going to look like this:
The most important thing I do to manage my portfolio is to ensuring that my actual asset allocation tracks my target asset allocation. At least once a year, I will rebalance my portfolio. Since I tend not to sell index funds, I use additional funds deposited into my accounts to purchase my way to the target allocation.
Next, I am going to cover the more sexy part of investing – the building of a portfolio. In Part 4A I will talk about building a core portfolio. Part 4B will discuss how I add oomph by buying dividend growth stocks.