To put it simply, asset allocation involves balancing risk and reward by diversifying among asset classes. If that sentence seems like it’s written in a foreign language to you, trust us, you aren’t alone! Asset allocation is a relatively complicated topic, but as investors, we need to not only understand it but also know how to use it to structure our investment portfolios.
According to Modern Portfolio Theory, asset allocation is the primary driver of portfolio return, with asset allocation accounting for over 90% of performance over time. That means other issues like market timing, individual security selection, and even fees, may be much smaller concerns for us as investors compared to asset allocation.
So what does asset allocation accomplish in our portfolios? Asset allocation is a means for achieving diversification, which allows us to minimize our risk compared to an undiversified portfolio. Imagine you’re holding a single pencil between your hands and try to break it in half – should be pretty easy, right? (If it isn’t, you should get our iron levels checked!). Now imagine you’re holding a whole bunch of pencils in your hands and are trying to break that stack – unless you’re The Hulk, you’re probably not doing much damage to the large bunch of pencils. Asset allocation gives you a whole bunch of pencils instead of a single pencil in your portfolio, which when executed properly should achieve a lower overall level of risk.
Consider asking yourself the following questions about your own asset allocation: does your current portfolio match your risk tolerance? Is your current allocation maximizing return for your given level of risk? Do you have a strategy in place to adjust your allocation as your risk tolerance changes over time? Do you have a systematic and/or strategic rebalancing plan in place for your portfolio?
If you answered “no” or “I don’t know” to any of these questions, you might benefit from some professional help when it comes to managing your investments. Send us a message (firstname.lastname@example.org) or give us a call (512-649-2383) to learn more.
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