On these very pages not too long ago, I pointed out the most important factor to achieving investing success, which is consistent accumulation. The second most important factor? Asset allocation.
Asset allocation is the process of dividing your investment “pile” into various different types of investments in an effort to maximize your exposure to the unique benefits of each type of asset class – while at the same time utilizing the risk as efficiently as possible.
When it comes to asset allocation, there are two primary factors which help to determine how you might allocate your investment assets: risk tolerance and time horizon.
Risk tolerance deals with whether or not you can sleep at night knowing that your investment could fall (or rise!) by 15%, for example. If you’re a person who feels compelled to monitor your investments every day and can’t stand it when you see a loss, you have a low tolerance for risk. If, however you recognize that it is important to take measured risks in order to achieve a better return, you may have a moderate tolerance for risk. On the third hand, if you consider the lottery, Texas Hold ‘Em, and day-trading penny stocks to be reasonable components of a portfolio, you may have an inappropriately large appetite for risk.
Risk is tempered by your time horizon. In other words, even if you’re fairly risk-averse, if your time horizon is long enough, you can (and should) take on a fairly risky allocation model. Conversely, when your time horizon is shorter, you may need to dial down the risk – even if you have a relatively high appetite for risk – the short time horizon reduces your ability to recover from significant losses should they occur.
What’s important to remember is that investing too conservatively early on in your savings career can have a drastic affect on the results. Since you have a significant amount of time for compounding to work in your favor, it makes sense to take additional risk to increase the overall return for your portfolio. With time on your side, you can afford to take a little more risk when the reward is appropriate.
At the same time, when your investing horizon is shorter, say less than five years, you can’t afford to put your funds at much risk. But this doesn’t mean that you should put your money under the mattress – inflation will eat away the buying power of your money in a short time. It’s important to maintain a degree of risk in your portfolio throughout your investing life in order to combat the impact of inflation and provide for a minimal amount of growth.
Once you determine an appropriate allocation model to follow, it makes sense to review and re-balance your portfolio about once a year – in order to make sure your allocation model is still in effect. Rebalancing more often doesn’t produce benefits to match the amount of effort and transaction costs that you would incur.