Your investment success

Asset allocation is a critical component of investing success. Research suggests that it is the most significant factor in how the returns of a portfolio vary over time, and that it strongly influences both the total long-term return and the risk of your investment portfolio.

Other factors, such as security selection and market timing, play a smaller role. Unfortunately, the most important decision for achieving financial success is also the least understood.

You have already seen what asset allocation is; however, most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments within groups of similar assets. If you ask investors to list the assets they would consider investing in, typical answers include “growth stocks,” “bonds,” “large caps,” and sometimes “international stocks.”

But their diversification is limited to selections within one asset class. For example, someone choosing to purchase technology stocks may invest in five or six companies, but all within the technology industry. That reduces risk if one of the companies fails, but it is of little use if the technology industry (or the entire stock market) slumps.

Asset allocation goes beyond simple diversification and reduces risk across all types of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Each of these can be further divided into subcategories; stocks, for example, include large-cap, mid-cap, small-cap, value, growth, international and domestic.

Similarly, bonds can be divided into subcategories such as short-term and long-term, tax-free, high-yield, convertible, emerging markets, floating rate, international and domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high-risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even in complete opposition to one another, can lower the risk of your entire portfolio.

For example, international stocks are considered “riskier” than domestic ones. Yet, US and international stock markets do not always move together: they often move by different amounts, and sometimes in opposite directions.

When two assets tend to move in opposite directions, this is called a negative correlation: the profits from one asset balance the losses from the other. US and international stocks are not negatively correlated (they usually move in the same direction, but not in lockstep). Even so, combining them can lower the risk of investing, by reducing the daily price swings of your entire portfolio.

History shows that some markets tend to move in opposite directions. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents a risk to any investor.

Choosing to buy only stocks, bonds, or any single asset class increases the risk of losing money if that market underperforms.

The power of asset allocation comes from lowering risk for a given level of expected return. Reducing risk by combining multiple asset classes, however, is not a simple process. While each asset has its own unique measure of risk, many assets share similar price behaviours (their prices go up and down together in any market).

Combining such similar investments increases the risk of wild changes in price. Trade-offs between asset risks and expected returns must also be considered. High-yield assets typically experience high volatility or large changes in price. These assets must be balanced by investments with lower rates of return to protect against large declines in value.

Successful asset allocation requires finding the proper mix of assets to balance reward with an acceptable level of risk. Proper allocation planning requires asset research and investment analysis.

Fortunately, tools are available to assist independent investors. Popular financial websites offer educational links and software that builds portfolio allocations from a questionnaire about your finances. For advanced investors, many books explain in detail the theory and practice of asset allocation, whose theoretical basis is Modern Portfolio Theory (MPT).

Casual investors can buy mutual funds designed to automate asset allocation based on an expected retirement date. Pragmatic investors can turn to the many financial planners and advisory services that offer asset allocation portfolios tailored to their needs.

Consider your options carefully. Each solution offers its own set of advantages and disadvantages. Pick a style that closely reflects your own. Just how important is asset allocation? It is the single largest determinant of your long-term financial success.