5 Simple Steps to Creating Proper Asset Allocation

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Creating a proper asset allocation is the first, best step toward becoming a successful investor. After all, it’s impossible to time the markets, and no matter how hard you try, you’ll have difficulty beating the market with any specific investment selections you make. Creating the proper asset mix then is the most substantial contribution you can make to your investment performance.

The reason it's so important to create proper asset allocations, is that it enables you to build “firewalls” between your assets, that will prevent you from being overly invested in any one investment asset, sector, or security.

That way you won't be subject to more risk than is absolutely necessary. Below are 5 steps you can take to reach proper asset allocation.

1. Take Your Emotional Temperature

No matter how much we may attempt to downplay their influence, emotions do play a significant role when it comes to investing money. How do you determine what your emotional temperature is where investing is concerned? There are multiple components:

Personal circumstances. This takes in marital and family status, job security, and debt levels. Each will reflect the amount of risk you can afford to take with your investments.

Your goals. Here you need to define your investment goals. Are you preparing for a college education for your children, retirement, early retirement or some other purpose? The goal can affect how you invest.

Your time horizon. Is your time horizon 40 years out, or just ten years? That will affect the amount of risk you can take on with your investments.

Your risk tolerance. In spite of the objective factors above, there may still be feelings — deep inside — that make you either a high risk investor, or someone who takes few chances.

Consider each of the factors above in determining how much risk you want to include with your investments, then make your asset allocations accordingly. For example, if you’re single, have a stable job, low debt levels, you’re planning for retirement in 40 years, and risk doesn’t bother you, you can consider putting 80% to 90% of your investments in risk-type assets.

If you’re 40, work on commission, have substantial debt, and are investing for your children’s college education in ten years, you might want to keep risk type investments down to the 50% level.

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2. Take the Guess Work Out

Picking winning investments is always a challenge, even for seasoned investors. For this reason, the largest percentage of your money should be in index funds and income-producing assets. The idea is to take the guesswork out of most of your portfolio, so your investments will thrive in most market environments.

Index funds. Very few investors can legitimately claim to beat the market over the long-term. For this reason, index funds, particularly those that are tied to the S&P 500, tend to be excellent long-term plays. You won’t beat the market, but you won’t get run over by it either.

Income-producing assets. This isn’t just bonds, but it can include them. An asset that provides an income stream isn’t relying on capital gains alone, and that can be a big advantage in down years in the market. High dividend-paying stocks may be the best choice since they provide dividend income but also capital appreciation. Bonds could serve primarily as a diversification.

3. Diversify Within Specific Asset Allocations

In addition to including various asset classes in your investment portfolio, you should also plan to diversify within each asset class.

Stocks. Though index funds tend to be the best all-weather stock investments, you can diversify your stock position by spreading your money across various sectors, each of which having the potential to outperform the general market at different times. For example, technology stocks could outperform the general market during a bull market. The defense sector could turn in positive returns even in a bear market if the geopolitical situation in the world is unstable. Here's our guide for how to invest in stocks.

Bonds. Though it may seem that bond holdings would require very little thought, the opposite is actually true. If you are holding corporate bonds, you may want to diversify those positions by adding treasury securities and municipal bonds. It’s also a good idea to stagger bond maturities, which will give you a better ability to react to a changing interest rate environment.

Though it may seem beneficial to create something of a “fire and forget” portfolio allocation, building flexibility into your investments should really be the goal. The financial markets are fluid, and you need to be able to roll with the changes.

4. Create a Small Allocation for Special Situations

Though you want to have your money primarily invested in index funds and income-producing assets, you should also plan on having a minority percentage allocated to special investment situations.

There are several possibilities here:

The trend du jour. This can involve allocating a larger percentage of your money to growth stocks during a bull market. The idea is to position your portfolio to take advantage of the current trend. While it’s true that trends can reverse in short order, they often go on for years. Allocating some extra money into that trend could increase your returns significantly.

High risk/high reward investments. There are certain investment types that represent significant risks, but also hold the potential to provide home-run type returns. This can be upstart companies in a new industry, a company with a new but unproven technology, or certain energy plays.

Distress situations. We can loosely think of this as value investing, but since such stocks are hard to come by these days, you may look for outright distress situations. This would involve buying stock in companies that are in serious trouble. The stock is beaten down by the market, to the point where there’s nowhere to go but up. But it’s never certain, because many of the problems that drove down the stock price have not yet been solved. It’s a waiting game, but one that can sometimes payoff handsomely.

When it comes to special situation investments, you want to put a small amount of your portfolio — probably not more than 10% — into the class as a whole. In addition, you’ll want to spread that money out over a dozen or more companies, with the idea that you only need two or three of them to turn around in order to achieve spectacular returns. Think of it as play money, but don‘t get addicted to it.

5. Add Some Alternative Investments

In addition to stocks and bonds, you should also seriously investigate alternative investments. These are less traditional holdings, but they are the type that can do extraordinarily well in certain types of markets, often those that are not favorable to stocks.

There’s a long list of possibilities here. Commodities quickly come to mind, as they represent unique opportunities to take advantage of weak spots in the general economy. For example, precious metals tend to do well when the dollar is weak. Energy tends to do well any time there’s anything that smacks of an energy shortage.

Real estate is another possibility, and there’s no single way to play the sector. You can certainly invest in small income property by becoming a landlord. But you can also invest in real estate partnerships and in real estate investment trusts (REITs) that will enable you to invest in a portfolio of similar properties.

Even more unconventional, is to invest directly in small businesses. You can do this by starting your own business — where better to invest your money than with yourself — or by providing private equity to other promising businesses.

By spreading your money across different asset classes, and across different investments within each class, you establish yourself as a long-term investor. You position yourself to be able to take advantage of various market conditions, and avoid being clobbered by others. Proper asset allocation is the key, and if you haven’t spent much time on that up to this point, take a break and study the possibilities.

There’s no one percentage allocation that will work for everyone. You have to decide your risk tolerance, and allocate your money based on how much risk you feel you can handle.

Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids.

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