Investing - Asset Allocation - Part 1


[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

Editor's Note: This post was published at the Carnival Of Investing #59.

All successful investors have demonstrated to us time and again that discipline and diligence are integral to long-term investing. Before we jump into the market with our hard earned money it is of utmost importance to figure out the asset allocation for our investments. In fact this is one of the very first steps to successful investing. Fueled with over enthusiasm our hands might itch to get into the investing game as quickly as possible. But it is for our own benefit that we should exercise patience and learn the basics well.

What is Asset Allocation?

Asset allocation is the process of determining the ratio or dollar amount for distributing our investments across various asset classes
. It is the technique of achieving diversification. The objective of doing so is to:
  • Minimize total risk for the entire portfolio of investments by not keeping all eggs in the same basket.
  • Maximize the probability to achieve an expected rate of return in order to attain a long term objective.
  • Distribute investments so that the assets outperforming the market can cushion the under performing assets.

What are the asset classes?

The major asset categories are Stocks, Bonds and Cash Equivalents.
  • Stocks - Also known as equities or ownerships in corporations, these have the greatest potential for long term growth. But at the same time they pose the highest amount of short term risks. Investments in this class are highly volatile in nature. However history has shown us that investors who are willing and are able to stay put for longer periods have been amply rewarded.
  • Bonds - These are debt obligations of various kinds. History shows that bonds have given lesser returns over longer periods as compared to stocks. They are usually much less volatile in nature and produce income. As a result they are preferred more by investors who have retired or are nearing retirement. Bonds can provide somewhat predictable regular income while having modest appreciation of capital as well.
  • Cash Equivalents - All kinds of cash deposits and savings accounts, certificate of desposits (CDs), money market accounts, money market funds constitute this class. The primary objective of cash equivalents is capital preservation. Most of these products are FDIC insured. We have to take care that the APY earned on cash equivalents is sufficient enough to beat inflation so that the capital is preserved.

How have asset classes performed?

Using historical data let us take a look at the performance of these asset classes.
  • Stocks
Historical Risk/Return (1960–2005)
Average annual return 10.5%
Best year (1975) 38.5%
Worst year (1974) –28.4%
Years with a loss 12

  • Bonds
Historical Risk/Return (1960–2005)
Average annual return 7.1%
Best year (1982) 31.1%
Worst year (1969) –8.1%
Years with a loss 5

  • Cash Equivalents - (1950 - 2005) - 5.31%
What should be my allocation?

For the benefit of our audience, we spent quite a bit of time searching for simple user friendly yet effective online asset allocation tools. We found that some websites have calculators to determine the allocation, while others provide static models for various scenarios of asset allocation. Calculators can be tuned and made more specific to meet our individual needs. In the following section we present a couple of the top calculators.

Calculators
There are only a handful of calculators available online. Often it is hard to find one that suits our specific needs. However we found two great realistic and easy to use calculators. Both of them are based on Java Applets and have intuitive user interfaces.
  • Smart Money offers a pretty neat calculator. To begin with, we need to enter a cash amount on the upper left region. As soon as we do that a pie chart appears in the lower right region. Next, we are required to use the sliders on the upper right region to tune it. We suggest choosing an inflation forecast of 4%. Finally, checking the radio button titled "ideal allocation" gives us our target allocation.
  • Bloomberg's calculator offers an additional slider for yearly savings along with other standard asset allocation sliders. The asset classes are more detailed here. For example, it shows percentage designations for Mid Cap stocks and Municipals which are absent in SmartMoney's calculator described above.

[Continued to Investing - Asset Allocation - Part 2]

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