Asset Allocation: Critical to Your Investment Success

Asset allocation is a critical component of investing success. Both research and academic studies show asset allocation to be single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio. Other factors such as security selection and market timing account for a very small percentage of your investment returns. Unfortunately, the most important decision to achieving financial success is also the least understood.

What is asset allocation? Most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments among groups of similar assets. Ask investors to list the assets in which they would consider investing. Typical answers include "growth stocks", "bonds", "large caps", and sometimes "international stocks." But their diversification is limited to selection within one asset. For example, someone choosing to purchase technology stocks may invest in five or six companies ? but all within the technology industry. This reduces risk if one of the companies should fail, but is useless when the technology industry (or entire stock market) slumps.

Asset allocation goes beyond diversification to reduce risk across all type of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Investments and risk can be divided further into subcategories of stocks including large-cap, mid-cap, small-cap, value vs. growth, and international vs. domestic. Similarly, bonds can be divided into subcategories of short-term, and long-term, tax-free, high yield, convertible, emerging markets, floating rate, and international vs. domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even opposite to each other, both increases the return and lowers the risk of an entire portfolio. For example, international stocks are considered "riskier" than domestic stocks. Yet, we often see the prices of U.S. stocks go up on the same day prices of international stocks go down -- and vice versa. We call this negative correlation. Profits from one asset balance the losses from another. Combining international and U.S. stocks actually lowers investment risk by reducing daily price swings of our entire portfolio.

History demonstrates many markets exhibit similar negative price correlation. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents risk to any investor. Choosing to purchase only stocks, only bonds, or any single asset class increases the risk of losing money if that market underperforms.

The power of asset allocation comes from reducing risk while increasing returns. Reducing risk by combining multiple asset classes, however, is not a simple process. While each asset has its own unique measure of risk, many assets share similar price behavior (their prices go up and down together in any market). Combining such complimentary investments increase the risk of wild changes in price. Trade-offs between asset risk and expected return must also be considered. High yield assets typically experience high volatility, or large changes in price. These assets must be balanced by investments with lower rates of return to protect against large declines in value.

Successful asset allocation requires finding the proper mix of assets to balance reward with an acceptable level of risk. Proper allocation planning requires asset research and investment analysis. Fortunately, tools are available to assist the independent investor. Popular financial websites offers independent investors help with educational links and software to build portfolio allocations based on a survey of financial questions. For advanced investors, many books have been written to painstakingly explain the theory and practice of asset allocation ? also called MPT (Modern Portfolio Theory). Casual investors can purchase mutual funds specifically designed to automate asset allocation based on an expected retirement date. Pragmatic investors can explore the many financial planners and advisory services that offer asset allocation portfolios specific to their needs.

Consider your options carefully. Each solution offers its own set of advantages and disadvantages. Pick a style that closely reflects your own. Just how important is asset allocation? It's the single largest determinant of your long-term financial success.

Tim Olson

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young, personal wealth management, and venture capital investing.

Trading Expert Discovers Ways To Beat Stock Market Odds With Money Management

The first point to mastering money management is that you... Read More

Success Trading: Yet More Basic Terminology for New Traders

In this day and age of online brokers for virtually... Read More

Copy Cat or How to Use a Successful Trading System

How many books have you read about successful traders? How... Read More

Just Say NO to Your Stock Broker

We have all heard that slogan that started back when... Read More

How to Invest Overseas - Intelligently!

In recent months, many advisors have talked a lot about... Read More

It?s Never too Early to Start Investing!

Remember the old saying, "never too late to start"? Well,... Read More

Everybody Wants to Know How to Invest

Those unfamiliar with the process of making and managing investments... Read More

Before You Start Investing

There maybe several reasons why you to want to invest... Read More

Four Key Components To Building A Trading System

Need some insight on what you should really be striving... Read More

Mutual Fund Returns May Not Be As They Seem!

Arthur Levitt, during his tenure at the SEC, experienced many... Read More

Making Every Penny Count

More and more workers are leaving their jobs and taking... Read More

Rolling your 401k: Contributory IRA vs. Rollover IRA

In an ideal world you would start your working career... Read More

The Real Cost of a Bad Habit

What is the value of a good habit? Think of... Read More

Your Worst Enemy To Successful Investing - The Media

How do you make your investment decisions and where do... Read More

How to Buy to Let

Find out everything you need to know about buy to... Read More

Retirement is Never Urgent Until

If you're like many people, your retirement savings have not... Read More

How to Calculate the Value of Your U.S. Savings Bonds

If you're like many Americans over the age of 55,... Read More

Beta Factors: How They Can Be Used In The Current Situation

Ever since the turn of the century, world stock markets... Read More

Moving Average Convergence Divergence ( MACD ) Charts

The Moving Average Convergence Divergence charts, or MACD charts for... Read More

Effective Advice For A New Generation of Investors

CATCHING A FALLING KNIFEOne of the most common mistakes made... Read More

Caveat Emptor: You May Owe Taxes Despite 401(K) Losses!

One among many ways you lose money in non-indexed mutual... Read More

Investing In or Owning Drug Lab Properties

Clean Up (includes the insides and the outside of a... Read More

The Economy Is Not The Stock Market

Several days ago, the Commerce Department reported that May's factory... Read More

Making Your Investment Dollars Work for You

Investments are scary for some people, especially those who have... Read More

How Eating Bitumen Made Me a Better Stock Trader

Stock market trading is a fascinating activity.There are so many... Read More