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You’ve probably already read here about the importance not “keeping all of your eggs in one basket” when you invest. In other words, have a few different types of investments so that if one tanks, your won’t loose your life savings all at once! This is called Asset Allocation in investing lingo, as explained more below.
There has been an ongoing debate about whether your investments do well because of the skill of the person choosing the investments, or because of the amounts you had in each type of investment at various times. Think of it this way. If you get into stocks, for example, near the very top of the market, you’ll have to ride down the inevitable looming drop when it does happen (which is fine for long term investors if this is what they choose). If you invest near the bottom of a market correction, you’ll have the pleasure of the ride up! This has a profound effect on how your money grows. The big picture then is how much money you had in stocks, not whether or not you bought Apple in the 1990’s.
Back to the debate about whether smart picking of stocks or bonds is more important than the overall amount you have in stocks or bonds. I recently found an important article online about how much of a portfolio’s performance is attributable to asset allocation. I have seen it referenced several times in the past and would like to share it with you as the point is super important for you to grasp.
According to the study done by Roger G. Ibbotson and Paul D. Kaplan more than 90% of the variability of performance over time is due to asset allocation. What does this mean? This means that the way you allocate your assets accounts (the amount you put into broad categories of stocks or bonds) accounts for 90% of the way your investments perform.
What is asset allocation exactly? Very simply put it means putting a set percentage of your assets into different types of investments. Let’s look at an example of asset allocation. A typical asset allocation could be 50% stocks 30% bonds and 20% cash. The actual amounts allocated in this example for a $ 1 000 000 portfolio would be $500 000 in stocks $300 000 in bonds and $200 000 in cash or cash equivalents.
A decision is made based on risk level and expected performance (of stocks, bonds, cash or even real estate) as to what percent should be allocated into various asset classes. An asset class is investing lingo for a type of investment, such as stocks or bonds. If the current price of the asset class is considered with regard to how an asset has performed in the past it is likely (but never guaranteed!) that the portfolio will perform better.
Various types of investments perform differently simply because of what is happening in the economy and other reasons. One may go up while another goes down or stays even. This study found that the way you have divided your assets into the different categories accounts for 90% of your portfolio’s performance. Understanding asset allocation then is paramount to wise investing.
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