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Asset allocation is a term that is often used but probably not really understood or at least not fully put into practice. The most common discussion will talk about the allocation between stocks and bonds. A common formula for asset allocation is to subtract your age from 110 so that if you are 30 you should have 80 percent in stocks and 20 percent in bonds. Well that might be fine if you're explaining asset allocation to a kindergartener but for someone who actually has money invested this is just too simplistic.
Hand in hand with asset allocation is diversification. But what is diversification really? Owning GE (industrial), IBM (computer) and Ford (Automotive) is not diversification. Nor is owning the stock of a large company, a medium sized company, and a small company. Yes you have a diverse selection but you are not diversified and you certainly are not properly allocated.
And to make things even more complicated I'll ask the question of whether it's possible to be properly diversified with an appropriate asset allocation if you're an active investor, someone who buys and sells stocks (or mutual funds) often.
Let's begin with what diversification is. Being diversified means that you own some amount of different types of investments. Stocks and bonds is one example but not enough. I believe you should have diverse stock or equity investments from large companies to medium and small as well as foreign stocks. It's all about slicing up an investment pie but be careful not to end up with really small pieces. You can further divide each category like taking large companies and dividing that into large growth or large value.
On the bond side I've added the category of commodities recently. It's arguable whether that should be included on the stock side or, as I chose, the bond side but I include commodities in a category I call cash/bonds/commodities since the price of my chosen commodity (precious metals) is not tied to a particular company as much as it is to the overall strength or weakness of the economy. If the stock market does poorly there will probably be a "flight to quality" increasing the appeal of commodities much as bonds often do better when stocks do poorly.
Once you decide on the amount of diversity, you'll need to figure out the allocation, how much do you want in large companies versus small companies versus bonds? I've chosen to keep things simple in my personal asset allocation which is divided into the following categories:
Large cap
Medium cap
Small cap
Bonds/Commodity/Cash
International
Misc Stocks
A little explanation. The three top stock categories are made up of both value and growth mutual funds but I choose not to break them out. The miscellaneous stocks category is my way of exercising my stock picking ability. I use this money to try my hand at winning big. But I don't put a lot into it because I'm not willing to risk a lot of money for a small chance of success. Now here's the same list with my present allocation:
Large Cap 35%
Medium Cap 20%
Small Cap 19%
Bonds/Commodities/Cash 14%
International 9%
Misc Stocks 3%
Some would consider that a very aggressive portfolio since my bond category only represents 14% and that includes cash as well as a commodity based mutual fund. I agree this isn't for the faint of heart and it certainly isn't for someone with a few years on me but considering my age 36 and my risk tolerance, this works well for me.
Trying to maintain this or any other asset allocation when you're constantly buying and selling stocks is difficult. I buy no load index mutual funds with extremely low expenses. Once I buy there is almost no reason to sell. And how have I done? Well in this post I compare my success with that of Jim Cramer. I won't spoil it for you but I will say you might be surprised who comes out ahead.
One last note on rebalancing your asset allocation. I don't necessarily rebalance at any particular time such as quarterly or yearly. As I add new money into my investments I'll put it where I'm lacking. For example is I find that I have only 15% in small caps then when I have money to invest that's where I'll put it, small caps. This strategy allows me to keep the portfolio in balance as I go.
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