Close-Up: Asset Allocation

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n.

Asset Allocation: The scientific process of creating a portfolio by selecting the most effective combination ofinvestments to meet the specific needs and goals of an individual investor.

We've heard about the dangers of putting all oureggs in 1 basket. To mix metaphors, betting theranch on a good poker hand could result in a windfall,but the odds are against that happening. More thanlikely, you'll lose the ranch. No matter how good yourinitial hand looks, it's impossible to guess which remainingcards will be dealt to you. Investing is no different.

"Investing, like poker, is a game of statistics," saysBard Malovany, CFP®, of the Financial Council. "You canbe a good poker player if you know all of the strategiesavailable and play your cards intelligently. The same istrue with investing."

The Complete Book of Money

Asset allocation is the scientific strategy thatenables individual investors to successfully play thestock market. Writing in ,Stephen Pollan notes that asset allocation is based onthe 3 most important factors of investing: risk, growth,and time. Different investments move in differentdirections at different times. Asset allocation allowsyou to minimize risk in your portfolio.

RISK/GROWTH RELATIONSHIP

When determining an asset allocation strategy, it'simportant to keep in mind that investments offeringthe greatest growth potential also present the greatestrisk. For example, if you build an aggressive growthportfolio of individual stocks and stock mutual funds,you are taking on considerably more risk than if youbuild a portfolio also comprised of government bondsand CDs. And because no 2 physician-investors areidentical in terms of their needs, circumstances, andpersonalities, risk is a very personal thing.

According to an "ING Financial Solutions Report,"risk is measured by standard deviation (ie, determininghow past returns vary from the average rate of returnover a given period of time). The higher the standarddeviation, the higher the price volatility and fluctuationare, and therefore, the greater the risk. Similarly,the lower the standard deviation, the lower the levelof investment risk will be.

Remember that varying investment classes behave differently.Blue chip stocks are less risky than growthstocks, and stock mutual funds are less risky than individualstocks. For that reason, some advisors advocate aflexible asset allocation strategy. "We always suggestthat investors have a range in mind," says GregoryBrown, CFA, CPA, senior vice president at Payden & Rygel(www.payden.com). "A 60%/40% mix historically hasbeen the place where investors get the optimal mix ofstocks and bonds. But the stock portion could range anywherefrom 40% to 70%, and bonds anywhere from30% to 60%. That way you can make shifts dependingon market conditions and circumstances in your life."

YOUR TIME HORIZON

All investment goals havea time horizon (ie, the lengthof time between when youstart investing and whenthe money being investedwill be used). Thathorizon could be short ifyou're saving for a newcar, or more long term ifyou're putting away moneyfor retirement or a child's collegeeducation. Whatever your investmentgoals are, their respective time horizons will impactyour asset allocation strategy. As time horizons shift,so should your asset allocation.

The rationale here is basic. Generally, you canassume greater risk and a higher potential return theyounger you are—if your investment goal is retirement—or the longer your investment goal's time horizonis. That's because your longer time horizon canbetter withstand the short-term price fluctuation ofyour investments. In other words, your risk toleranceis higher because you have a longer period of timewithin which you can recoup some short-term losses.If, however, you're saving to buy a new home within3 to 5 years, your investment portfolio should containa greater concentration of low-risk bond funds oreven money market accounts.

Clearly, asset allocation is 1 of the most importantinvestment decisions you will ever need to make.There are no off-the-shelf formulas available. Howyou allocate your money depends on your individualneeds, goals, circumstances, and appetite for risk. AsPollan notes, no 2 asset allocation formulas shouldbe identical. After all, they're not cars being massproducedon an assembly line. Asset allocationshould be a custom job.

Asset Allocation Through the YearsAsset allocation scenarios change as we enterdifferent stages of life. According to the CalvertGroup, investors should seek to minimize risk asthey get closer to withdrawing funds from theirinvestment portfolio. Below are sample asset allocationstrategies depending on your time horizon.Keep in mind that your financial advisor can helpyou determine the appropriate asset allocationstrategy for your situation.

• 20- to 30-year time horizon: 75% stocks/20%bonds/5% money market. Even though you have alonger investment time horizon, it's still a wisemove to allocate a small portion of your portfolioto bond and money market funds for near-termgoals and liquidity.

• 10- to 20-year time horizon: 60% stocks/30%bonds/10% money market. As your time horizonbegins to shorten, bond and money market fundsbecome even more important portfolio components.

• 5- to 10-year time horizon: 30% stocks/50%bonds/20% money market. As retirement approaches,the income generated from bond funds could providea key portion of an investor's monthly cash flow.

CME Quiz

1) Asset allocation is:

1. An investment strategy
2. A diversified mutual fund
3. A new virtual investment game
4. A waste of time

2) An aggressive-growth portfolio equals:

1. Moderate risk
2. Increased risk
3. Low risk
4. No risk

3) A long time horizon allows investors to take on more:

1. Credit
2. Risk
3. Insurance
4. Advisors

4) Historically, an optimal mix of stocks and bonds is:

1. 60%/40%
2. 50%/50%
3. 40%/60%
4. 80%/20%

5) With a 5- to 10-year time horizon, 50% of yourinvestments should be in:

1. Stocks
2. Money market accounts
3. CDs
4. Bonds

Answers: 1) a; 2) b; 3) b; 4) a; 5) d.