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 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.

Aggressive portfolio
Moderately aggressive portfolio
Moderate portfolio

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.

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.

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.

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.

People who are less inclined to while away their days thinking about statistics and standard deviations can still employ these techniques.

Imitate the experts

For investors who want to explore a bit out of their depth, learning to optimally combine mutual funds of varying market capitalizations and valuations according to their own risk tolerance can help them engineer their own portfolios successfully — no market timing required.

Resources abound in the form of asset allocation strategies from people who have already done the math. Simply follow a model that has been developed based on statistics from the last 50 to 100 years, says Tom Ruggie, Certified Financial Planner and founder of Ruggie Wealth Management.

“Realistically, they can put their money into an asset allocation plan and, given a long enough time frame, there is some predictability as to what will happen,” he says.

Of course, since they’re built on historical models, there are no guarantees.

The important thing is that investors understand why they’re investing in different asset classes and how they work together. Do enough research on specific investments to feel confident about your choices. Understanding the reason for choosing each investment may help you stick with your portfolio through good markets and bad.

“In our workshops and podcast, what we do is show people the very best way that we think they can build a portfolio for all seasons,” says Thomas Cock Jr., financial educator with Merriman Berkman Next.

“Not shifting from this asset to that asset — we are not trying to chase what is going on with commodities for instance, but what we are trying to do is get people to have a global diversification of a great variety of asset classes,” he says. 

How to get started

Portfolios will be divided first into two pieces: equity and fixed-income. Some younger investors could dispense with the fixed income side altogether.

“Young people should be all in stocks,” says Cock. By young, he means until age 30 or 35.

You may be called upon to summon patience, fortitude and perspective to wait out any dips in the market, prolonged as they may be. 

“Unfortunately what I have seen is that people graduate from college, get a job, get into all stocks and then stocks go down for three or four years,” Cock says.

Then they move everything into bonds and say bonds don’t work either, he says.

“Essentially, they become bad market timers, moving in and out of the market at the wrong times.”

The asset classes

For those who don’t want to run the risk of seeing upward of 20 percent of their investments evaporate in a given period, fixed-income investments, or bonds, provide stability to a portfolio. As far as investment returns go, bonds generally perform more consistently, though less spectacularly, than equities.

Through the steady influence of bond returns, potentially volatile markets can be mitigated to some extent.

On the other hand when equities are doing well, their returns outstrip bonds. So the proportion of fixed income to stocks should be determined according to risk tolerance and desired return.

Both international and domestic equity investments can be further broken down into market capitalization segments and valuation. 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 companies are generally more volatile than larger, more established companies, so they’re inherently riskier.

Across large, mid and small caps, companies are categorized based on how the market assesses them — whether as value stocks or growth stocks, or a blend of the two.

“A growth company would be one whose earnings are expected to grow very rapidly. These tend to be very glamorous companies,” says Bernstein. “Good companies, great companies — the kind of companies that get on the Forbes most-admired list.”

Value stocks aren’t nearly as exciting. “They are stocks that are limited in growth for some reason,” says Kevin Brosious, CPA, Certified Financial Planner and president of Wealth Management.

At first glance it may seem obvious that going all-growth would be the smart thing to do. But not so fast.

It turns out that value stocks have higher returns than growth companies, Bernstein says.

“It’s very counterintuitive but in fact they do (get higher returns). And the reason for this is almost certainly because investors tend to overprice growth stocks. Everybody wants to be associated with a growth stock,” he says.

Risk vs. return

But one shouldn’t discount growth stocks entirely. Individual asset classes have their day in the sun, and they will flounder at some point, too.

“We don’t know what will be the best (asset category) for the next 30 years,” says Cock. “We’re not really into betting on what the market may do. What we do want to do is expose clients to all of these asset classes that in combination have worked very well because they are non-correlating.”

“While large may be out of favor, as it was in 2002, small did OK. And while growth was out of favor, value did OK.”

Unless you’re investing only in broad indexes — which isn’t necessarily a bad idea according to Bernstein, combining mutual funds made up of value stocks and growth stocks adds more diversity to your portfolio. These assets are likely to move in varying patterns, thus mitigating risk.

Which comes back to an essential piece of portfolio theory: The amount of return you desire must be weighed against the amount of risk you are willing to take.

It’s all fun and games when everyone is making money, but when the market declines, you want to know that you have chosen your investments based on sound principles.

Planning your portfolio to weather all kinds of market conditions over a long period of time should bolster your confidence through good markets and bad. After all, saving for retirement is a long-term project. So it requires an investment strategy that will hold up for a long time.

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