Asset Allocation – Earn More from the Your Investments

"Horse sense is what keeps horses from betting on what people do." - Raymond Nash

This Investment Guide Lesson focuses on asset allocation. But first I must share a difficult confession. Most of us suffer from being all too human. It is natural when we have a lot of money at stake to have strong emotions about it. On occasion many of us rail between being carelessly confident gamblers and "Chicken Littles" - who are all too eager to abandon the situation.

Before getting into the details, I want you, the reader, to get excited about asset allocation. The most challenging aspect of investing is understanding when to buy and when to sell equities. In the world of investing, like comic delivery, timing is everything. Asset allocation is a simple and incredibly powerful tool that aids you in these decisions. Asset allocation helps any investor to look past his emotions and invest with cool sophistication and success.

What is asset allocation? Think about the classic pie chart. Start by taking each of your investments and plot them as a percentage of your total portfolio in a pie chart. This is getting close to an asset allocation graph. Asset allocation goes one step further and lumps the investments into categories. Generally, these categories are determined by their relative risk for the investor in the investment portfolio.

This investment guide lesson's goal is to reduce the complexity of investment down to what is essential for success. For the purpose of this lesson, asset allocation shall simply be the total amount of cash, bonds, bond funds and bond ETF's (low risk) versus the total amount of stocks, mutual funds and stock ETF's (higher risk) for a given investment portfolio. The total amount of low risk investments divided by the total amount of high-risk investments is the cash to equity ratio.

How does asset allocation work in practice and why is this so important? Let us take a particular investor. She has decided that a ratio of 40% cash to 60% equity is ideal for her. Recently, the stock market went down by 15%. Every three months she readjusts her ratio. She found that the cash position grew to 44.0% and the equity position dropped to 56.0%. She sells 4.0% of her portfolio and takes this from bonds and purchases the same amount in stocks. Now her ratio is back to 40/60 or 0.667.

What just happened here? She did one of the smartest things an investor can ever do. She bought stocks low! She has an investment friend that does not believe in asset allocation. Her investment friend was busy selling his stocks, criticizing her purchases and trusting his hunches on when to buyback into the stock market.

Next quarter, the stock market goes up by 20%. Her cash position drops to 35.7% and her equity position rises to 64.3%. Now she readjusts her ratio again. She sells 4.3% of the portfolio and takes this from her stocks and buys 4.3% more in bonds. What is the consequence? She just did another smart thing. She sold stocks high and kept her profits by placing the money back to nice safe cash.

Her unfortunate friend was slow to recognize that stocks moved up substantially and he pours his cash into a peaking stock market, only to get meager returns. She bought stocks low and sold them high. This is a great deal for her! While at the same time her friend sold stocks low and bought stocks high. This is not a good deal for her friend.

There are other more subtle benefits to asset allocation. Not only does it tell you when to buy and sell, it also tells you how much. Also, asset allocation takes the emotion out of buying and selling stocks. This is a very important concept. The natural human behavior is to sell stocks after they go down and buy stocks after they go up. In addition, the more the stock market goes down, the more stocks people want to sell. Likewise, the natural human emotion is to purchase more stocks after the stock market goes up. Further they purchase more stocks than what is justified for the market move.

Studies on this subject very but investors that practice this type of asset allocation receive an annual 2% to 5% of additional profits. Conversely, if an investor uses his "gut feeling" about stocks, then he shall have this 2% to 5% loss working against him. Now you can see why the average investor is not making much headway on his retirement in the stock market.

Through the magic of compounding investments, this small percentage really increases your worth over a lifetime. Let us say you are investing $500 per month for 25 years. Also, you are an "average" investor and get 10.59% annual return on your investment in an S&P 500 index ETF. After 25 years you are worth $734,000.00 - not bad.

Let us assume a typical asset allocation strategy returns another 2.5% per year. On the other hand if an investor uses his feelings, hunches, to judge when to buy and sell stocks, his returns are penalized by 2.5%. In the last case, the hunch investor is only worth $483,000 better than nothing. However the investor that practices asset allocation is worth $1,123,000 dollars - wow! Yes, you can become a millionaire by following a simple investment strategy combined with asset allocation!

Asset allocation does require a little extra work. As the stock market rises and falls, your ratio of cash to equity changes. It is extremely important to bring the ratio back to your personal goal on a regular basis. We saw an example of this earlier with our lady investor. The process of doing this is called "leveling" your portfolio. Choose 1 month, 1 quarter, 6 months or no less than a year period for leveling.

A handy equation for leveling your portfolio is:

LV = (C (R * E)) / (R + 1)

Where:

LV = Leveling Value or the total money to take from cash part of a portfolio and add to the equity portion of the portfolio to achieve your desired cash to equity ratio.

C = Cash or the total value of low risk assets such as cash and bonds

R = Ratio, your desired cash to equity ratio, C/E

E = Equity or the total value of all risky assets, such as stocks, mutual funds and ETF's.

When the stock market goes down LV is positive. When the stock market goes up LV is negative. When LV is negative, this is the amount of money to add to your cash position and subtract from your equity position.

Now you have the tools and I hope the inspiration to practice asset allocation in your own investing. This wonderfully simple process makes a world of difference in investment performance. Asset allocation takes an ordinary investor and turns him into a wealthy professional!

"The only time you find success before work is in the dictionary." - May V. Smith

Asset Allocation Earn More from the Your Investments

By: Mark Elliot

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