Institutional

Asset Allocation – A Guide to Balancing Risk and Return

By David N. Chazin
Asset allocation, how an investor distributes his investments among various classes of investment vehicles (e.g., stocks and bonds), is a long-term strategy that uses a variety of asset classes in one portfolio to manage risk against potential returns. The goal is to balance your risk tolerance, financial needs, and time horizon. Each asset class plays a specific role and has individual characteristics that may cause it to perform better than other types of investments under certain market conditions.

Asset allocation can move through a life cycle along with you. As you transition to different stages in your life, your investment portfolio follows the same shifts. The stages include Accumulation, Protection, Income Management, and Transfer. Each generally requires a different portfolio allocation and type of financial product.

Keep in mind that asset allocation does not ensure a profit or protect against a loss. Asset allocation may not be appropriate for all investors, particularly those interested in directing the underlying investment options on their own.

Different asset classes have historically produced distinctly different returns over time. Asset allocation attempts to manage portfolio risk and profit around those differences. A study by Ibbotson Associates in April 2006 compared the range of annual returns across six different asset classes: small company stocks, large company stocks, corporate bonds, long-term government bonds, intermediate-term government bonds, and 30-day treasury bills.

Small company stocks (based on companies listed on the major U.S. exchanges valued at less than $2 billion) produced the best range of annual total returns of all major asset classes between 1926 and 2005, but also the biggest losses. Treasury bills (based on a monthly portfolio containing the shortest-term bill having at least one month to maturity) had no negative returns over the same period, but had the smallest average annual gains. Keep in mind, however, that past performance does not guarantee future results. Also note that indexes are unmanaged and are not available for direct investment, and that the values were calculated assuming reinvestment of dividends.

Risk, which is based on standard deviation, measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns.

One way to help protect yourself from market volatility is to diversify your portfolio with an assortment of asset classes. A single asset may expose you to higher levels of risk; however, simply adding one or two additional asset classes may not be enough. The important thing is to try to include assets that do not behave in the same way, meaning that their returns have tended to trend in opposite directions in years past.

Your goal with a well-diversified portfolio is less potential overall risk and more consistent returns over time. Remember, diversification can help reduce volatility, but it does not eliminate risk, does not guarantee a profitable investment return, and does not guarantee against a loss. It is simply a strategy used to manage risk.

By spreading your investments over a wider range of asset classes, you’ll be less likely to expose any single asset class to the effects of unpredictable shifts in the financial environment. A fully diversified portfolio rests on a broader foundation and may provide the stability needed to weather market changes over longer periods of time.

Two important points to consider:

• First, no one asset class outperforms all the time. The winners can quickly become the losers.
• Second, a diversified portfolio, consisting of equal shares of each different asset class, provides more consistent returns as the individual winners and losers within a given year help balance one another.

A financial planner is qualified to help you determine the proper mix of assets in your portfolio, and to help you select the investment options that are best suited to your individual circumstances.

Although asset allocation cannot guarantee a return on your investments, or protect against a loss, it can help you:

• Formulate a way to help you achieve your retirement income security goals.
• Assess your future financial needs, taking into account the following factors:
o Current savings from all sources (UCRP/pension, UC retirement plans, IRAs, investments)
o Cost of living (housing, utilities, travel, out-of-pocket expenses, entertainment, gifts)
o Expected inflation rate
o Risk tolerance
• Reevaluate your asset allocation at least once a year to make sure you’re on track, and rebalance your portfolio to maintain your target weightings.
• Adjust your asset allocation as you transition from accumulating assets to spending them in retirement. Remember, many financial professionals recommend maintaining some exposure to equities during retirement as a hedge against inflation and to preserve your buying power, but it is important to consider your situation to determine what’s right for you.

By taking control over your retirement income security strategy and setting realistic expectations, you can indeed achieve the confidence to succeed and the retirement you deserve.

Please contact us at (800) 318-7848 with specific questions or to schedule a time to meet in either our San Ramon or Livermore office (about a mile from the lab).
To learn more about what Insight Wealth Strategies can do for you or your colleagues, please email us at info@insight2wealth.com or fill out the request information form.

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