Asset allocation reduces volatility
|By Jenny McCune
Your retirement nest egg shouldn't actually be one egg, but many, and you definitely don't want to put them all in one basket.
That's the philosophy behind
asset allocation, the practice of dividing
your retirement savings among different asset
classes. You put one egg into stocks, another
into bonds, yet another in real estate, and
No, you won't end up with scrambled
eggs. By spreading your money around into
different categories of investments, you can
minimize risk and maximize performance. How
does this happen? When you diversify among
investments with little correlation to one
another, some assets will go up while others
go down. When they move in opposition to one
another, they have a negative correlation.
In effect, this helps stabilize the portfolio
and reduce overall volatility.
|Asset allocation basics
For example, studies show that
Real Estate Investment Trusts (REITs) have
little correlation to the stock market. "In
'98, the stock market was going through the
roof while Real Estate Investment Trusts were
losing ground," says Doug Charney, senior
vice president of the Charney Investment Group
of Wachovia Securities. "The opposite
was true in 2001 and 2002. Stocks were down
while real estate was doing well."
Bonds also performed well during the two-year period when stocks were sucking wind.
That's why asset allocation is so important.
"It doesn't eliminate risk, but it helps
you deal with it," says Stuart Ritter,
a certified financial planner with T. Rowe
Price. "When something bad is happening
in international stocks, your technology stocks
may be doing well and the impact on your portfolio
allocation is by far the most important
thing that you can do.”
Investors often focus too much
on choosing the right mutual fund rather than
looking at how they are divvying up their
retirement savings. It may not be as much
fun as choosing the next high-flying, emerging
markets fund or acting on a hot stock tip
from your brother-in-law, but asset allocation
can translate into more money for your retirement.
"Asset allocation is by
far the most important thing that you can
do," says Jerry Miccolis, a certified
financial planner with Brinton Eaton Wealth
Advisors in Morristown, N.J. "It is more
important than which mutual funds you invest
in or what stocks you buy. Getting asset allocation
right is 80 percent or 90 percent of the game."
These are typical asset categories:
Stocks have several subcategories according to size, price and other financial characteristics. These include value, growth, large-cap, mid-cap, small-cap, domestic, foreign and emerging markets. They can also be classified by sector, specific geographic regions and other variables. Generally, stocks offer the highest returns but carry the most risk.