Asset Allocation Basics

by Dual Income No Kids on July 15, 2009 · 0 comments

Hi All,

We picked up a primer on asset allocation in Portland last weekend, so you should be hearing a lot more about this topic over the next few weeks. However, if you aren’t familiar with buying stocks, asset allocation is an important topic. Persons interested in maximizing their wealth should have an adequate command of the basics.

Essentially, asset allocation is the process of deciding how to divvy up your investment dollars among various types of resources. More generally asset allocation is also an approach to investing which emphasizes diversification.

Asset allocation has four basic concepts:

1) A fundamental relationship between investment risk and return.
– The main idea here is you need to incur greater risk to yield a greater gain. Of course, the relationship between risk and return is far from perfect – that is – you won’t automatically get more money if you incur higher risk. Also, each individual has what’s called their own “efficiency frontier”, which means in economic terms, that individuals each have their own optimal mix of risk and return.

2) Asset class selection – determining which investments are right for you.
– Asset classes are different types of investments. The main idea is that the different types of investments have different characteristics. Right, some are more tax efficient than others, some have higher creditworthiness, others provide protection from inflation, etc. etc.

3) Determining what mix of investments is right for you.
– In addition to finding out what assets you want, you need to find out what the best mix of them is. The statistical metric that is used to measure how well asset classes go together is called “correlation”. It’s an important concept because you want a mix of assets that are negatively correlated. This means that if one of your assets declines in value, then others may go up. For example, if you own stocks and gold; when stocks decline, gold may go up. The idea about mixing your resources is to reduce your risk by being sure you have some negative correlation in your portfolio. The only reason you should want to take on more risk is in order to get higher gains, or build your wealth more rapidly.

4) Rebalancing your portfolio to keep it optimized.
– The real world is constantly fluctuating. Economic change causes some business to do better than others. You can’t just set up your asset mix and call it good. The major issue is your assets will grow at different rates, thus causing your portfolio to drift away from its optimal configuration. In order to address this, you have to periodically buy and sell assets. This is known as “rebalancing” your wealth. Rebalancing can help your portfolio by causing you to buy low and sell high as well as by exploiting natural fluctuations in the stock market to get extra return.

So, those are the basics. Stay tuned for more or feel free to pick up a copy of Asset Allocation For Dummies. The book is available at the World’s greatest bookstore. Powells, for $22.00. My advice, check out the google preview or get the e version, they’re cheaper.

Best,

James

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