Asset Allocation the Key to Disciplined Investing

By Jane Young, CFP, EA

Your asset allocation is the way you divide your money between different asset classes including stock, bonds, and cash equivalents. Different asset classes react differently to changes in the economy and the market. Combined, holding different asset classes results in a diversified portfolio with less volatility. You can reduce risk by spreading money across different asset classes. A diversified portfolio minimizes the impact of poor performance by any one investment on the overall portfolio.

Your asset allocation serves as a road map of how your money should be invested. Committing to an asset allocation gives you the discipline to stick to your plan during major market fluctuations. One of the biggest investment challenges is managing your emotions when markets fluctuate. Overreacting to market volatility is a major threat to reaching your long-term financial goals. Following an asset allocation makes it easier to stay the course and resist the temptation to make emotional decisions.

Several studies have found that asset allocation has more influence on portfolio performance than any other investment decision. According to a study by Vanguard, asset allocation is responsible for 90% of the return on your portfolio over the long-term. They found that security selection and market timing only accounted for 10% of the return.

Your objective in determining the right asset allocation is to get the highest return based on the amount of risk you are comfortable taking.  Your portfolio needs to be safe enough to stay the course during major market declines and aggressive enough to meet your long-term financial goals.  The appropriate asset allocation is based on your investment goals, risk tolerance, other sources of income, the value of your portfolio, time horizon, and cash flow needs.  There is no one size fits all, the appropriate allocation depends on your unique situation.

Your asset allocation is the foundation of your investment strategy. It will change throughout your life as your financial situation, your goals, and your ability to tolerate risk changes. Significant life events such as a new job, a significant raise, children, marriage, divorce, retirement, a major windfall, a serious illness, and a change in cash flow needs, may warrant a change to your allocation. You should only make changes to your investment strategy in the context of your long-term investment plan and changes to your situation, not out of concern about current market conditions.  

Establishing a portfolio based on your asset allocation is not a one-time event. Rebalance your portfolio at least annually to stay on target. You will also want to diversify your portfolio within each asset class. For example, the stock portion of your portfolio should be invested in a wide variety of large, small, international, and domestic companies.  The use of low-cost mutual funds and exchange traded funds (ETFs) can make it easy for you to diversify across hundreds of different companies across all industries.