retirement

Asset allocation helps mitigate risk

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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