Asset allocation is a strategy, advocated
by modern portfolio theory, for maximizing gains while
minimizing risks in your investment portfolio. Specifically,
asset allocation means dividing your assets among different
broad categories of investments, including stocks, bonds,
and cash
equivalents.
Determining the asset allocation model — specifically
the percentages of your portfolio allocated to each investment
category — that’s appropriate for you depends
on many factors, such as how much time you have to invest,
your tolerance for risk, and your investment goals.
For example, one investor might choose to invest 70% of
her money in stock and stock mutual funds, 20% in bonds,
5% in REITs,
and 5% in cash equivalents, while another might decide
to split his money evenly between stocks and bonds only.
These two portfolios will produce different returns, due
partly to the difference in their asset allocation models.
Ibbotson’s research shows that, on average, 40% of
the return difference between one portfolio and another
is explained by the different asset allocations. So, if
the first portfolio returns 5% more than the second, then
on average about 2% of the difference (40% of 5%) is explained
by the different asset allocations, while the remaining
3% difference (60% of 5%) is explained by security selection,
timing, and fee differences.
Setting your asset allocation is the single most important
decision you can make as an investor. (That is, once you’ve
decided to invest at all!) That’s because, on average,
investors don’t beat the market: In general, their
portfolios don’t perform better than the overall
market, regardless of the individual stocks, bonds, and
mutual funds they select. This means that for the average
investor, the asset allocation mix they choose — what
percentage of stocks, bonds, cash, and other asset
classes they include in their portfolio — accounts
for 100% of their return level.
Professor Roger
Ibbotson of Yale University, chairman and founder of Ibbotson
Associates
