Here's the ideal scenario: Investors can get rich without taking any risk.
But this is the reality: Investments that potentially offer high returns generally come with high risk -- meaning they can swing both ways, sometimes causing painful losses.
Asset allocation is an investment strategy
that can help your portfolio produce optimal returns
while mitigating risk. In fact, a famous study done
in the 1980s concluded that asset allocation accounts
for more than 90 percent of the variance of a portfolio's
return.
Just as most people would not be well-served with a million-dollar portfolio devoted entirely to one hot stock, it would be an equally imprudent investing strategy to dump everything in short-term Treasuries. Sacrificing return for safety may seem like a good idea -- especially when the market is tanking -- but for long-term investors, it's not.
Instead, diversifying across a broad range of asset classes will help lower risk while providing returns to carry you through your retirement.
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Aggressive portfolio |
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Moderately aggressive portfolio |
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Moderate portfolio |
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Don't know an emerging markets fund from a REIT?
Find the descriptions of each individual asset class by rolling your mouse over the slices of these asset allocation charts.
Notice that the aggressive portfolio contains no fixed income (fancy word for bonds). The moderately aggressive portfolio has 16 percent allocated to bonds, while the moderate portfolio has a 40 percent allocation.
Source: Charts are courtesy of Merriman Berkman Next.
 10% international small cap blend Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
International funds invest in companies outside of the United States. In this case 'international' refers to a fund that invests primarily in businesses in developed countries.
Because international small cap value stocks are represented in the portfolio separately, this blend should have a growth tilt. Growth stocks generally exhibit high earnings growth and strong return on equity.
10% international large cap blend This asset class concentrates on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In order to diversify the portfolio with as many non-correlating classes as possible, this asset class should have a growth tilt, as is the case with the small cap blend.
Growth stocks generally exhibit high earnings growth and strong return on equity.
10% international large cap value This asset class focuses on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
10% international small cap value Small companies in developed nations excluding the U.S. that are underappreciated by investors are represented by this section of the portfolio.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
10% U.S. large value Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. American companies designated as large cap have the same market capitalization as international counterparts: more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
10% REITS Real Estate Investment Trusts invest in commercial real estate, from shopping malls to timberlands and sometimes in mortgages. REITs sell on the major exchanges as stocks but can be owned in a mutual fund or ETF.
10% U.S. micro cap Micro caps in general are a very volatile asset class but there are index funds that invest in many small companies, thus mitigating the risk for individual investors.
Micro cap companies have a market capitalization between $50 million and $300 million.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share.
10% U.S. small value Small cap companies have a market capitalization between $300 million and $2 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
10% S&P 500 The Standard and Poor's 500 consists of 500 large-cap stocks and serves as a benchmark for the overall U.S. stock market. Many index funds attempt to match the performance of the S&P 500 by holding the same stocks in the same proportions.
10% emerging markets Emerging markets funds generally invest in companies in developing countries with less sophisticated financial markets. These funds can either invest in a specific country, region or a group of developing countries. Because of the economic and political instability in some of the countries, these funds tend to be more volatile.
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Don't know an emerging markets fund from a REIT?
Find the descriptions of each individual asset class by rolling your mouse over the slices of these asset allocation charts.
Notice that the aggressive portfolio contains no fixed income (fancy word for bonds). The moderately aggressive portfolio has 16 percent allocated to bonds, while the moderate portfolio has a 40 percent allocation.
Source: Charts are courtesy of Merriman Berkman Next.
4% TIPS Treasury Inflation-Protected Securities (TIPS) are inflation-adjusted bonds issued by the U.S. Treasury.
The principal is periodically adjusted for inflation, and the semi-annual coupon (fixed interest) rate is paid on the adjusted principal. You pay tax annually on the interest payment. A drawback is that you also pay tax annually on the adjustment to the principal, even though you don't receive the adjustment until you redeem the bond.
TIPS are also available in mutual funds or ETFs.
6% short term bond Short-term bonds have a maturity of less than five years.
Bonds are IOUs from corporations or the government. As an investor, you lend money for a specified period of time and the interest you're paid is the yield on that bond.
Longer-term bonds generally have higher yields but they are also riskier in two ways: interest rates and inflation may rise higher than the yield on a long term bond, and there is always the risk of a default on the loan, though not for U.S. Treasuries.
Using bond funds or ETFs make fixed-income investing fairly easy. There are funds to match all levels of risk tolerance, from those that invest only in very stable, high-quality bonds to those that buy risky high-yield junk bonds.
10% intermediate bond Intermediate-term bonds, generally with maturities of between five to 10 years, are a way of getting more interest without being locked in for long periods of time -- 30 years, for example, for a Treasury bond.
Longer-term bonds generally have higher yields but they are also riskier in two ways: interest rates and inflation may rise higher than the yield on a long term bond, and there is always the risk of a default on the loan, though not for U.S. Treasuries. Intermediate-term bonds fall between short-term and long-term bonds in the risk spectrum.
8% international small cap blend Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
International funds invest in companies outside of the United States. In this case 'international' refers to a fund that invests primarily in businesses in developed countries.
Because international small cap value stocks are represented in the portfolio separately, this blend should have a growth tilt. Growth stocks generally exhibit high earnings growth and strong return on equity.
8% international large cap blend This asset class concentrates on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In order to diversify the portfolio with as many non-correlating classes as possible, this asset class should have a growth tilt, as is the case with the small cap blend.
Growth stocks generally exhibit high earnings growth and strong return on equity.
8% international large cap value This asset class focuses on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
8% international small cap value Small companies in developed nations excluding the U.S. that are underappreciated by investors are represented by this section of the portfolio.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
8% U.S. large cap value Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. American companies designated as large cap have the same market capitalization as international counterparts: more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
8% REITS Real Estate Investment Trusts invest in commercial real estate, from shopping malls to timberlands and sometimes in mortgages. REITs sell on the major exchanges as stocks but can be owned in a mutual fund or ETF.
8% U.S. micro cap Micro caps in general are a very volatile asset class but there are index funds that invest in many small companies, thus mitigating the risk for individual investors.
Micro cap companies have a market capitalization between $50 million and $300 million.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share.
8% U.S. small cap value Small cap companies have a market capitalization between $300 million and $2 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
8% S&P 500 The Standard and Poor's 500 consists of 500 large-cap stocks and serves as a benchmark for the overall U.S. stock market. Many index funds attempt to match the performance of the S&P 500 by holding the same stocks in the same proportions.
8% emerging markets Emerging markets funds generally invest in companies in developing countries with less sophisticated financial markets. These funds can either invest in a specific country, region or a group of developing countries. Because of the economic and political instability in some of the countries, these funds tend to be more volatile.
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Don't know an emerging markets fund from a REIT?
Find the descriptions of each individual asset class by rolling your mouse over the slices of these asset allocation charts.
Notice that the aggressive portfolio contains no fixed income (fancy word for bonds). The moderately aggressive portfolio has 16 percent allocated to bonds, while the moderate portfolio has a 40 percent allocation.
Source: Charts are courtesy of Merriman Berkman Next.
12% short term bond Short-term bonds have a maturity of less than five years.
Bonds are IOUs from corporations or the government. As an investor, you lend money for a specified period of time and the interest you're paid is the yield on that bond.
Longer-term bonds generally have higher yields but they are also riskier in two ways: interest rates and inflation may rise higher than the yield on a long term bond, and there is always the risk of a default on the loan, though not for U.S. Treasuries.
Using bond funds or ETFs make fixed-income investing fairly easy. There are funds to match all levels of risk tolerance, from those that invest only in very stable, high-quality bonds to those that buy risky high-yield junk bonds.
20% intermediate bond Intermediate-term bonds, generally with maturities of between five to 10 years, are a way of getting more interest without being locked in for long periods of time -- 30 years, for example, for a Treasury bond.
Longer-term bonds generally have higher yields but they are also riskier in two ways: interest rates and inflation may rise higher than the yield on a long term bond, and there is always the risk of a default on the loan, though not for U.S. Treasuries. Intermediate-term bonds fall between short-term and long-term bonds in the risk spectrum.
8% TIPS Treasury Inflation-Protected Securities (TIPS) are inflation-adjusted bonds issued by the U.S. Treasury.
The principal is periodically adjusted for inflation, and the semi-annual coupon (fixed interest) rate is paid on the adjusted principal. You pay tax annually on the interest payment. A drawback is that you also pay tax annually on the adjustment to the principal, even though you don't receive the adjustment until you redeem the bond.
TIPS are also available in mutual funds or ETFs.
6% international small cap blend Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
International funds invest in companies outside of the United States. In this case 'international' refers to a fund that invests primarily in businesses in developed countries.
Because international small cap value stocks are represented in the portfolio separately, this blend should have a growth tilt. Growth stocks generally exhibit high earnings growth and strong return on equity.
6% international large cap blend This asset class concentrates on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In order to diversify the portfolio with as many non-correlating classes as possible, this asset class should have a growth tilt, as is the case with the small cap blend.
Growth stocks generally exhibit high earnings growth and strong return on equity.
6% international large cap value This asset class focuses on large companies in developed countries excluding the U.S.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Large cap companies have a market capitalization of more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
6% international small cap value Small companies in developed nations excluding the U.S. that are underappreciated by investors are represented by this section of the portfolio.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. Small cap companies have a market capitalization between $300 million and $2 billion.
6% U.S. large cap value Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share. American companies designated as large cap have the same market capitalization as international counterparts: more than $10 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
6% REITS Real Estate Investment Trusts invest in commercial real estate, from shopping malls to timberlands and sometimes in mortgages. REITs sell on the major exchanges as stocks but can be owned in a mutual fund or ETF.
6% U.S. micro cap Micro caps in general are a very volatile asset class but there are index funds that invest in many small companies, thus mitigating the risk for individual investors.
Micro cap companies have a market capitalization between $50 million and $300 million.
Market capitalization refers to the size of the company as measured by the number of shares of stock outstanding multiplied by the price per share.
6% U.S. small cap value Small cap companies have a market capitalization between $300 million and $2 billion.
In general, value stocks are cheap, with share prices low relative to earnings and book value. Value stocks are underpriced by Wall Street or investors and often pay dividends.
6% S&P 500 The Standard and Poor's 500 consists of 500 large-cap stocks and serves as a benchmark for the overall U.S. stock market. Many index funds attempt to match the performance of the S&P 500 by holding the same stocks in the same proportions.
6% emerging markets Emerging markets funds generally invest in companies in developing countries with less sophisticated financial markets. These funds can either invest in a specific country, region or a group of developing countries. Because of the economic and political instability in some of the countries, these funds tend to be more volatile.
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Portfolio theory
Asset allocation is the art of purposefully building a portfolio made up of different kinds of investments that are not correlated to one another.
"Asset allocation comes out of portfolio theory. It is the end result," says William Bernstein, author of "The Intelligent Asset Allocator" and "The Four Pillars of Investing: Lessons for Building a Winning Portfolio."
Portfolio theory quantifies how investors can put together a portfolio of non-correlated assets for a given return at a given rate of risk.
It's heavy on math and chockfull of numbers and squiggly Greek symbols, so really getting into the nitty-gritty of it takes some dedicated effort. Sophisticated investors can calculate their level of risk and expected returns based on statistics and historical data.
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Updated: Aug. 11, 2008 |
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