Your investment success

Asset allocation is a critical component of investing success. Both research and academic studies demonstrate that asset allocation is the single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio.

Other factors, such as security selection and market timing account for a small percentage of your investment returns. Unfortunately, the most important decision to achieving financial success is also the least understood.

You have already seen what asset allocation is; however, most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments among groups of similar assets. Ask investors to list the assets in which they would consider investing. Typical answers include “growth stocks,” “bonds,” “large caps,” and sometimes “international stocks.”

But their diversification is limited to selections within one asset. For example, someone choosing to purchase technology stocks may invest in five or six companies, but all within the technology industry. That reduces risks if one of the companies should fail, but is useless if the technology industry (or the entire stock market) slumps.

Asset allocation goes beyond diversification to reduce the risks across all types of financial assets (cash, stocks, bonds, commodities, real estate, and even venture-capital for hedge funds). Investments and risks and investments can be further divided into subcategories of stocks that include large-cap, mid-cap, small-cap, value vs growth and international vs domestic.

Similarly, bonds can be divided into subcategories Of short and long-term, tax-free, high-yield, convertible, emerging markets, floating rate and international vs domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high-risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even in complete opposition to one another, both increases return and lowers the risks for your entire portfolio.

For example, international stocks are considered “riskier” than domestic ones. Yet, we often see the U.S. stock prices go up on the same day international stock prices go down, and vice versa.

This is called a negative correlation. Profits from one asset balance the losses from another. Combining international and U.S. stocks actually lowers the risks of investing by reducing the daily price swings of your entire portfolio.

History demonstrates how several markets exhibit similar negative price correlations. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents a risk to any investor.

Choosing to only purchase stocks, bonds, or any single asset class, increases the risks of losing money if that market underperforms.

The power of asset allocation comes from reducing risks whilst increasing returns. Reducing risks by combining multiple asset classes, however, is not a simple process. While each asset has its own unique measure of risk, many assets share similar price behaviours (their prices go up and down together in any market).

Combining such complementary investments increases the risks of wild changes in price. Trade-offs between asset risks and expected returns must also be considered. High-yield assets typically experience high volatility or large changes in price. These assets must be balanced by investments with lower rates of return to protect against large declines in value.

Successful asset allocation requires finding the proper mix of assets to balance reward with an acceptable level of risk. Proper allocation planning requires asset research and investment analysis.

Fortunately, tools are available to assist independent investors. Popular financial websites offer independent investors help with educational links and software to build portfolio allocations based on a survey of financial questions. For advanced investors, many books have been written to painstakingly explain the theory and practice of asset allocation, also called MPT (Modern Portfolio Theory).

Casual investors can purchase mutual funds specifically designed to automate asset allocation based on an expected retirement date. Pragmatic investors can explore the many financial planners and advisory services that offer asset allocation portfolios specific to their needs.

Consider your options carefully. Each solution offers its own set of advantages and disadvantages. Pick a style that closely reflects your own. Just how important is asset allocation? It is the single largest determinant of your long-term financial success.