Asset Allocation: The First Step Toward Profit

Financial advisors and brokers, either full or limited service, rarely provide investors with an adequate and concise overview of the investment market. At least, not such that decisions on asset allocation can be made. Investors are faced with a plethora of options on where to put new money; a situation which is often overwhelming.

A primary investment decision is to choose asset classes, particularly equities or fixed income. This decision needs to be considered because each investor has unique objectives. Choosing between equities or fixed income, as well as making investment choices, affects the ability to achieve investment objectives. Individuals need to consider market conditions that are expected to persist over the coming months or years and the influence of economic policy, as well as individual circumstances.

Investment Decision Making
Asset allocation is a term tossed around by investment professionals to describe how to distribute investment dollars in order to achieve an expected rate of return based on certain factors. Individual investors should consider these factors, including current income and expected future income, investment time horizon and tax implications, to name a few. Over any 20-year period, investment returns from various asset classes have been mixed, thus resulting in high returns for one or a couple of consecutive years followed by low returns.

This means that if an investor puts all of his eggs in the same basket year after year, he will receive lower and more volatile returns than if he "spread" his investment dollars among various asset classes. There are decisions to be made regarding which asset classes to spread or to allocate investment dollars because certain combinations of investments are based upon the degree of aggressiveness (or risk tolerance) needed to meet objectives. Degree of aggressiveness is determined based on a person's age and time horizon as well as tax status.

In addition to the long-term perspective inherent in asset allocation decisions based on specific investment objectives, short-term effects on investments need also be taken into account. Short-term and long-term considerations can include, but are not limited to, interest rates and the policies of the Fed, economic outlook and currency.

For example, there are certain investments that do better in a low interest rate environment (equities over fixed income) and some that do well in a rising inflation environment, like treasury inflation protected securities (TIPS) and commodities, that protect the value of the asset (hard assets over soft assets). Currency fluctuations also affect investments. For example, if the dollar is weak vs. foreign currency from country X, then a company domiciled in the U.S. and has its expenses in U.S. dollars, but makes a majority of its revenue from country X, will likely benefit from the weak U.S. dollar. Therefore, the choice of asset class is an important decision for both a short- and long-term investment horizon.

Overview of the Asset Classes
Asset classes include equities and fixed income. Investing in equities means that the shareholder is a part owner in the company - he/she has an equity interest in the company but in the case of bankruptcy, has very little to no claim, resulting in a risky investment. Fixed income means that the investor receives a predetermined stream of income from the investment, usually in the form of a coupon, and in the event of bankruptcy, has senior claim to liquidated assets compared to shareholders. The fixed income traded in the public market is typically in the form of bonds.

Asset classes can be broken up into sub-classes. Sub-classes for equities include domestic, international (developed and developing or emerging countries) and global (both domestic and international). Within these divisions, equities can further be grouped by sectors such as energy, financials, commodities, health care, industrials etc. And within the sectors, equities can be grouped again by size or market capitalization, from small cap (under $2 billion) to mid cap ($2 billion-10 billion) to large caps (over $10 billion) stocks.

Sub-classes for fixed income include investment-grade corporate bonds, government bonds (treasuries) and high yield or junk bonds. The importance of breaking investments down into sub-classes is to manage the degree of risk generally associated with the investment. Investing in companies with small capitalizations and in developing countries has historically been more risky, but has had greater potential for higher returns than investments in large capitalizations, domestic companies. Similarly, due to its junior status to bonds, equity is generally considered more risky than fixed income.

Strategy
Proper asset allocation is the key to providing the best returns over the long term, but there are some general rules of thumb when investing that can help guide through the short term, normal fluctuations of the market. In the short term (one- to three-year time frame), the economy and economic policies of the government have significant influence on investment returns.

  • Rule 1 - The stock market is a leading indicator, so its movement often precedes change in the economy that impacts labor, consumer sentiment and company earnings.
  • Rule 2 - Policy and the impact of decision making by the government due to various economic data are mid to lagging indicators as to what the market is doing.
  • Rule 3 - If you watch money flows (movement of money into and out of a particular stock, sector or asset class), when the chart shows a peak or bottom in money flow, you should do the opposite. Basically, a contrarian view may be best in this circumstance.
  • Rule 4 - Options are most profitable in volatile markets. A good indicator of market volatility is the VIX (Chicago Board Options Exchange Volatility Index). At times when the VIX is expected to move higher, investing in options rather than owning the equity may sometimes be more profitable and less risky.
  • Rule 5 - If there is a worry about rising inflation, buying protection via TIPS or hard assets like commodities usually insulates a portfolio.
  • Rule 6 - In a market that is continually moving up, stock selection is often less important than buying the market, thus buying a market ETF or index fund may lead to high returns with lower risk. But in a market that is moving sideways, stock selection is key and investors need to understand the growth drivers of a company's stock.

The Bottom Line
Designing a portfolio that performs well in both the long and short term is obviously not easy to accomplish. However, weeding out a lot of the noise and concentrating on some simple rules in the short term, while focusing on proper and re-balanced asset allocation in the long term, can steer investors to a model portfolio that should produce less risky, more stable returns.

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