Asset Allocation: Putting it all together

OK, we’ve got stocks and bonds, and different categories of each. The initial question is why should we invest in these different asset classes? We like a stock, say General Electric, so just buy that stock, collect the dividend, and watch the stock grow, or, since generally stocks have a higher return than bonds, so just buy a stock fund, sit back, and watch your portfolio shoot through the roof, right?

The answer, as is most of the answers concerning investing (and nearly everything else) is “it depends…”

Asset allocation depends mainly on risk, both the risk tolerance of the investor and the risks of the investments.

First, we look at the risk tolerance of the investor. This is usually guided by the reason for investing and the associated time frame, but it also based on personal preference. Stocks generally earn a greater return over the long term, but are more volatile over the short term. Therefore, the shorter the time frame for the investment (trip next year, retirement in three years…), the more conservative you would want to be in your investments in order to preserve the principle while still making a little bit of money. In addition the investor may be a risk taker or risk averse, which would also influence the types of investments: more stocks for the risk taker, and more bonds bonds for the risk averse.

The second is the risk involved in the different types of investments. Stocks are riskier than bonds, but in the asset classes, different investments have different risks, and therefore provide different returns. For example, large cap blue-chip stocks are generally less risky than small-cap growth stocks, and U.S federal government bonds are generally less risky than junk bonds. Different types of investments perform differently in different situations.

Therefore, the idea is to develop the least riskiest portfolio of investments that match the risk tolerance of the investor. An extremely risk averse investor and/or someone looking to invest for a very short very period of time would have a more conservative portfolio, with the least risky investments, such as bonds or money market funds. Someone who is risk tolerant and/or operating on a longer time frame would put their money mainly into stocks, and could go for riskier stocks, such as small cap, emerging market, or sector-specific. These stocks have more risk, but that goes along with a potentially greater return. However, the key is to diversify your holdings, based on the fact that different asset types are not correlated, so that the risk of having one part of your portfolio fall in value will be offset by an increase in another set of holdings.

All of this, by the way, is known as modern portfolio theory, which was developed by Harry Markowitz, and earned him and a couple of other guys the 1990 Nobel Prize in Economics.

A good place to go to analyze your portfolio or develop a hypothetical portfolio based on different assumptions is Morningstar Tools section.