Understanding asset allocation
By Jim Middlemiss • Bankrate.com

Most investors fret over which stocks, bonds or mutual funds they should buy. While that's certainly an important question, it's not the first thing they need to concern themselves with when building an investment portfolio, experts says.

Rather, the more important decision is how much money investors should allot to each of the different types of investments in their portfolio, known as asset allocation.

It's important because studies suggest that 90 percent of a portfolio's return is attributable to asset allocation or the investment mix. It's also important because a diversified portfolio, featuring a range of stocks, bonds, mutual funds and cash investments, can protect investors when market cyclones hit.

Think of the poor investor who didn't spread his money across more than one investment during the tech boom. If a person bought 1,000 shares of Nortel at its $124 peak, that $124,000 investment would now be worth less than $4,370 at today's share price of $4.37.

Asset allocation is about one thing -- better managing investment risk, and by doing that, creating consistent performance and a decent return.

Determine your risk tolerance
It's all about "worry-free investing," says Catherine Owens, vice-president of investment management services at Manulife Financial in Toronto. "One of the primary benefits to portfolio diversification is to mitigate risks."

Asset allocation recognizes that the market is in a constant state of flux, and it looks to smooth out the bumps and eliminate futile attempts to time the markets. The goal, Owens says, is to find the "efficient frontier," which is a portfolio that represents the optimum return for each level of risk.

Lisa Ball, regional manager of BMO Mutual Funds in Halifax, says "people try to overcomplicate investing." There are really three options: investors can deposit their cash in a savings account, buy fixed income or invest in equities, by either buying stocks directly or some type of mutual or exchange-traded fund that comprises as basket of securities.

Determining what percentage of a portfolio should make up each category is the challenge, says Derek Young, a Boston-based CFA and portfolio strategist at Fidelity Investments. "Generally, younger investors have the ability to take on more risk," so they can have a higher percentage of their assets tied up in equity investments, which are the riskiest asset class, and less exposure to fixed income and cash, the more stable asset class. "As you get older you should move into a more-conservative stage," he says, and have more exposure to fixed income and cash.

What investors need to do is determine their investment objectives and measure their appetite for risk, says Joseph O'Donnell, a portfolio manager and financial adviser with RBC Dominion Securities in Fredericton, NB.

When you open an investment account, most firms will test your risk tolerance by asking a range of questions about how conservative or aggressive you are, how much you can stomach losses in your portfolio, the type of gains you desire, your investment time frame and age. Based on that, they can develop an asset mix tailored to a specific individual.

Some banks have online tools, either on their public site or available once investors log in, that walk them through a questionnaire and proposes an asset allocation mix.

Look at different types of diversification
Simply splitting your assets among the three major asset classes is only the beginning, experts say. Investors can drill down much further to diversify their portfolio.

"It depends on how sophisticated you are financially and how much you like this field," says Moshe Milevsky, a professor of finance at the Schulich School of Business at Toronto's York University.

For example, after asset class, investors should look to diversify by geography. Ball notes that Canada accounts for only about two percent of the global economy. "You want to diversify elsewhere. We know there are a lot of great countries in the world. We don't want to pick just one."

As well, mix up the investment style when it comes to the equity component, says O'Donnell, and have a blend of at least four different approaches to stock picking. Look for:

Value: These are typically out-of-favour stocks that are on sale but have good future potential to provide steady returns.

Growth: These stocks favor earnings momentum and they often have high price-to-earnings (P/E) ratios.

Deep value: These companies are deeply discounted due to some type of distress. They've missed their earnings or face a scandal, but the investor still believes there is a worthwhile investment underneath the noise.

Growth at a reasonable price (GARP): Here, the company earnings are growing faster than its P/E ratio, so it's an undervalued growth company.

Another level of asset allocation is market capitalization, says Owens. Here investors have the choice of small-cap, mid-cap and large-cap companies. These often go hand-in-hand with investment style, so you could have a small-cap value fund or a mid-cap growth fund.

In his book "The Intelligent Asset Allocator," William Bernstein looked at the returns of large- and small-cap stocks from 1925 to 2000. He found large companies returned 8 percent annually while small caps returned 9 percent. However, investors take on more risk with smaller companies. During the Great Depression, small caps lost 85 percent of their value compared to large companies, which only lost about 67 percent.

As well, you want to make sure you're diversified by industry and that your asset allocation mix isn't simply focused on a range of financial institutions or technology companies.

How much is enough?
So how many investments do you need to be properly diversified in your equity portfolio? That depends on whom you ask. Young suggests 20 to 30, while Milevsky favors 30 to 40. O'Donnell favours 12 to 15 stocks, while Owens says it could be as little as five to 10 to cover North America. It really depends on your asset mix and appetite for risk, but "risk reduction comes at the expense of performance," notes Milevsky.

Establishing an asset-allocation mix doesn't end the investing process. Once it's in place, it needs to be monitored and rebalanced on a regular basis because some asset classes will perform well and others will perform poorly. So if you establish a mix of 50 percent in equities, 45 percent in fixed income and 5 percent in cash, after six months, equities might account for 43 percent and fixed income 51 percent and cash 6 percent. To rebalance, you would reduce the cash and fixed income levels and beef up equity exposure to return to your original weighting.

O'Donnell suggests using automatic rebalancing software. "It helps to take the emotion away from the decision-making process, allowing investors to follow through with a disciplined and proven investment strategy."

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He is a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.