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Wed. Feb. 20, 2008

Rev-up Your Portfolio With Asset Allocation *

Asset allocation describes how an investor distributes their investments among various classes of investment options (e.g., stocks and bonds). Most successful investors will tell you that asset allocation is the most important decision you make in determining how well your portfolio performs. As noted in my recent article Charlie Munger’s 10 Rules for Investment Success, he pointed out “Allocate assets wisely: Proper allocation of capital is an investor’s No. 1 job.”

The conceptual foundation of asset allocation is the premise that the best-performing asset(s) will vary from year-to-year and is not easily predictable. By spreading your investments across various asset classes, some will be over-performing while under-performing – Don’t put all your eggs in one basket. With fixed percentages on each of the asset classes you reallocate out of the better performing assets into the under-performing assets – Buy Low, Sell High.

Examples of asset allocation classes include, by asset type: Cash, Bonds, Stocks, Real Estate, Currencies, Natural Resources, Precious Metals, Collectibles, etc.

When looking at equities they can be sub-divided into additional asset classes grouped by:

  • Size such as: Large-Cap, Mid-Cap and Small-Cap
  • Style such as: Growth, Blend and Value
  • Sector such as: Financial, Consumer, Industrial, Health-care, etc.
  • Other such as: REITS, International, Emerging Markets, Life Settlements

Individuals determine which mix of assets to hold in their portfolio based largely on their time horizon and ability to tolerate risk. Time horizon is the expected period of time (months, years, or decades) you will be investing to achieve a particular financial goal. Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. When it comes to investing, risk and reward are often directly related. Over 20 years you will likely not lose any money investing in a federally insured money market account (MMA), but you will likely earn less than you would in an S&P index fund. Though in any given year the index fund could lose money, and over the 20 years will likely have several years in which it loses money – No pain, no gain.

There are a lot of tools available on the web to help you determine your asset allocation. Here are three, one very simple and the other two a little more comprehensive:

Once your asset allocation is set, it is not changed often. The most common reason for changing your asset allocation is a change in your time horizon. As you approach your investment goal, such as retirement, you may want to reevaluate your risk profile. It is important to note that savvy investors typically do not change their asset allocation based on the relative performance of asset categories.

As described in my article “Process Overview and Asset Allocation“, I currently allocate assets broadly by the type of investment (mutual funds, ETFs, dividend stocks) with some attention given to sectors within my dividend stocks. I am currently working on refining my process and will discuss this in future posts.

If you are interested in learning more about asset allocation, The U.S. Securities and Exchange Commission (SEC) has a good primer on asset allocation titled “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing“.

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7 Responses to “Rev-up Your Portfolio With Asset Allocation *”

  1. Passive Income says:

    D4L,
    About 3 months ago, while wondering in internet wilderness, I somehow stumbled upon your blog. I browsed it for sometime and got completely hooked up. You have an excellent blog here dedicated to your own approach to dividend based investing. Additionally, the links to other dividend bloggers is very good. I congratulate you on your effort. I am regular visitor now. A closing question: What are your thoughts on assessing personal finance based on networth ?

  2. RacerX says:

    Great post. Charlie is really amazing as well. It is one of those cases that if he worked with anyone else he would be praised even more. Mr B carries a long shadow!

    Thanks

  3. Dividends4Life says:

    Passive Income: Well I am sure glad you found my small spot on the web!

    Net worth works for some people and others it doesn’t. Though I track my net worth, I don’t consider it a particularly meaningful number for me since so much of my net worth is tied up in my company’s stock (401k, options, performance shares, restricted shares, and regular shares). It currently makes up 40+% of my portfolio. Over the last several years it has quadrupled, only to be cut in half over the last 12-18 months. So my net worth is all over the place and has little to do with my own investment decisions.

    As noted in my goals/progress section, I prefer to track annual dividend income and yield on cost within the income portion of my portfolio. Both of these I can exert some control over.

    RacerX: Thanks. I couldn’t agree more. Some have said Charlie may be the better investor. I would certainly take either as my personal adviser. :)

    Best Wishes,
    D4L

  4. Dominican says:

    D4L,

    I recently found your website via Old School Investor. I read this article and thought I would comment on your understanding of what Mr. Munger meant by diversification. In the September 2008 issue of Smart Money, Munger is quoted saying “People say the whole secret of investing is diversification…. that idea is ass-backwards”. Both him and Buffet have long said that they use common sense and bet big on whatever they find to be a good deal. My perception has been that they are not worried about short term fluctuations since they are so confident in the future outcome. Its almost like they invest with no finish line in sight. Where most of us are investing to retire.

  5. Dividends4Life says:

    Dominican: You are correct. Both Buffet and Munger will concentrate investments in companies they have throughly researched and feel confident in. Most of us mere mortals don’t have the insight, connections, time and resources to develop the confidence necessary to make concentrated investments.

    I would note also, through time Buffet has achieved a degree of diversification with in BRK.A’s total portfolio, albeit it was achieved through years of concentrated investments.

    Best Wishes,
    D4L

  6. Lightway says:

    D4L,

    I’ve seen a few of your articles lately discussing Asset Allocation. My question for you is, does your Asset Allocation strategy overlap your Dividend/Income portfolio? Or are you keeping two separate portfolios, one for Asset Allocation (Capital growth), and another for Dividends/Income?

    Thanks,

    Lightway

  7. Lightway: I consider my asset allocation in total – across all of my investments. Take a look at these articles:

    Measuring Asset Allocation Across Your Entire Portfolio
    2009-Q1 Progress Review

    Best Wishes,
    D4L