The importance of asset allocation in investing

There are many important decisions one must make when deciding how to invest. Many people tend to focus on picking the right stock or getting into the market at the right time. However, perhaps the most important and often overlooked decision is an investor's asset allocation. Asset allocation is the process of balancing risk and reward by apportioning a portfolio's assets according to an investor's goals, risk tolerance and investment horizon. Asset allocation was first developed by Harry Markowitz, a Nobel Prize winning economist. Markowitz illustrated how much risk a given portfolio would incur versus its expected return. The resulting graph, known as the efficient frontier, allows investors to use their risk tolerance and financial goals to determine how their portfolio should be constructed. In 2000, Ibbotson and Kaplan studied the importance of asset allocation and published "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" They concluded that asset allocation explained 40 percent of the variation of returns across funds and explained virtually 100 percent of the level of fund returns. While there are several theories on how to achieve the optimal portfolio, it most certainly is not an exact science. You must take into account not only risk and return factors, but also the condition of the markets. Investors must be disciplined to stay within their risk tolerance, while consciously adjusting their asset mix. If stocks fall 25 percent in a year when bonds return 5 percent, a 50/50 asset mix now looks more like a 40 percent stock/60 percent bond mix. Monthly, quarterly, or annually rebalancing of a portfolio has the added benefit of causing an investor to move money away from the asset class that has performed well, into the underperforming asset. For example, if an investor purchased $100,000 of stocks and $100,000 of bonds on June 30, 2004, their portfolio would have been worth $373,781 10 years later, providing an annualized return of 6.45 percent. If that same investor had purchased the same investments and rebalanced their portfolio at the end of each quarter, the portfolio would be worth $386,080, providing an annualized return of 6.80 percent. That is an extra $12,299 for simply rebalancing the portfolio to the targeted allocation. As you can see, choosing the right asset allocation is extremely important to achieving your financial goals. If an investor can maintain a long-term outlook and be disciplined enough to rebalance, there is a great chance they will meet their goals. If this seems too complicated or cumbersome, do not hesitate to contact a financial advisor to assist you in this extremely important decision. ----- Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management. He can be reached at (585) 586-4680. Published: Fri, Aug 22, 2014