Perhaps it's only human, but when the investment markets teeter, people want to do something. This fear of the unknown has given rise to elaborate timing techniques promoted as the panacea for market volatility.
This reactivity may ease one's nerves, but history reveals a dismal track record for market timing. It is doomed to fail because it ignores these truths:
- Reactive investing is always a day late.
- Asset groups behave cyclically.
- There's more safety in diversity.
Asset allocation, a relatively new investment approach gaining favor among institutional investors and professional money managers, has proven its superiority to timing and prediction. More recently, individuals have started implementing it in their own portfolios.
It involves diversifying assets among several investment groups in order to maximize returns while minimizing risk. It is the only scientific strategy that blends portfolio diversification, long-term trends and the specific level of risk you want to assume into a personalized investment plan.
Risk and return
Asset allocation starts with your needs as identified in your financial goals and anticipated money requirements through each major stage of your life. The risk level you are willing to assume is integral to forming this plan, and the principles of risk and return guide your decisions. Remember that in the risk- reward spectrum, there is no free lunch. A higher targeted return means assuming a higher level of uncertainty.
You achieve an "efficient" portfolio by striking an optimal mix between return and risk. In other words, you try to meet your goals without assuming more risk than necessary. Different combinations of investments will produce varying degrees of risk and overall return.
Asset groups do not behave the same way at the same time, and asset allocation diversifies money across a broad spectrum of investment groups to capitalize on this countercyclical behavior. It incorporates performance histories into computer programs to develop a portfolio compatible with your risk-return profile. The resulting plan should tell you how much money to invest in each asset category and the likelihood of achieving the stated investment goal.
A new perspective
Asset allocation takes portfolio diversification to a new level of sophistication. It is designed to do more than simply spread risk. It also takes into account the synergy achieved over time by efficiently mixing assets in weighted amounts.
And what does all this do for you? For one, it changes your investment perspective. When stocks fall, oil prices drop, or gold skyrockets, you don't feel the urge to do something. (In fact, you may not do anything at all.) Because your asset allocation model has already accounted for this volatility, you don't worry about it.
This disciplined, systematic approach to investing protects you from impulsiveness while providing enough flexibility to capitalize on opportunities unveiled throughout the cycle. While other investors are purging their portfolios based on yesterday's events, you are fine-tuning yours in anticipation of future trends.
Asset allocation is probably the most personal investment approach because it takes shape from your attitudes regarding risk and wealth. Furthermore, it changes with your changing needs. As you move through different financial stages of life, you adjust the portfolio accordingly.
A solution for the '90s?
Some analysts frequently speak of "the uncertain financial markets of the '90s" as if past decades were full of certainty. Where was the "certainty" in World War II, Korea, the Cuban Missile Crisis or the Arab Oil Embargo?
Only the past is in clear view. Asset allocation relies on the notion that long-term trends are more easily recognized than short-term fluctuations. A mountain of information is available to plot the behavior of stocks, bonds, international securities, precious metals, oil and gas, real estate and other major asset groups in varying economic conditions. A financial advisor can use it to apply allocation strategies to your portfolio. Mutual funds can also play a vital role in this process, as you can combine them to achieve the desired effect. There are even asset allocation funds.
Asset allocation provides a balanced, rational approach to building long-term wealth. If implemented with discipline, it can bring order to a permanently uncertain investment environment.
In the next chapter we talk about mutual funds, and about an asset allocation service that uses mutual funds as part of its program.
About the Author
For twenty years Adam Starchild
has been writing books about
these subjects, and they are published by a variety of publishers. They are
available in many bookstores or public libraries.
For more information on global investing, see The Offshore
Copyright © 1995 by Adam Starchild
The Investor's Library has reprinted this copyrighted article with the permission of the author.