Investors business
The cornerstone of any investment strategy is to maximize return while maintaining a tolerable risk. The process of allocating assets among several investment categories is a way of achieving this goal. The level of "tolerable" risk depends on an individual's psychological makeup, financial position and stage in life. Younger people can assume greater risks than someone who is retired; a highly paid executive will be less dependent on current portfolio income than will a disabled person on workmen's compensation and so forth.
Asset allocation can be handled in two steps. The first decision involves a general review of these financial, psychological and life stage factors to determine overall investment goals. Formulating decisions on these overall investment objectives is known as strategic asset allocation. It is a process that sets out the broad tone of your investment policy and one that should be reviewed periodically as your status in life changes .
WHY ASSLOCATE ASSETS.
There are three principal reasons for an investor to allocate assets: to reduce risk through diversification, to allow for the times when a specific asset is attractive and the times when it is not and to reduce the emotional aspect of decision making by carefully and gradually shifting emphasis from one type of asset to another.
RISK REDUCTION THROUGH DIVERSIFICATION .
It is a well known investment principle that you should not put all of your eggs into one basket. After all, what might seem to be a no-lose, high-reward situation at the outset may turn out to be a loser in the long run. Investing in more than one vehicle helps to cushion your portfolio in case one of your selections does not turn out to be as profitable as was originally expected. Asset allocation involves a lot more than just buying several different stocks; it also encompasses cash, bonds and inflation hedge assets. In its purest form the asset allocation process would also include other asset classes such as real estate, oil leases, annuities and so forth. Because these are not as liquid as assets like equities and bonds, they are not considered.
The simplest way to allocate assets would be to hold small amounts in a variety of financial vehicles and never sell. Such a policy would cushion a portfolio from major stock market declines like the 1987 crash. At the same time it would also participate well in major bull markets.
There are two problems with this approach. First, a major bull market in a specific asset, such as that for equities in the 1980s, would increase the proportion of that particular asset category well above the original intention. To make matters worse, this over weighting would occur right at the most inappropriate time the top of the market. One of the principal objectives of asset allocation is to increase the allocation of an asset class in the area of a major bottom, not at a market top. Eventually it would become evident that this static approach would have to be adjusted or the portfolio would become skewed toward one particular asset, thereby diluting the beneficial effects of diversification.
The second advantage of a static approach is that if consistently fails to take full advantage of major bull markets and does little to provide protection during bear markets. No approach can guarantee full participation in every bull move or liquidation at the beginning of every bear market. Nevertheless, a continuous and conservative alteration in the asset balance as a response to changing economic environments is achievable and can result in superior, although not necessarily spectacular, results.
The idea of improving the risk or reward ratio is a key one in money management. All investments involve some kind of risk, but one of the principal objectives of investing is to limit risk as much as possible while not giving up too much on the reward side.
PHYSIOLOGICAL ASPECTS OF INVESTING .
It is a relatively easy task to gain a theoretical understanding of why markets move up and down. Beating the market on paper is not that difficult, but actually that knowledge to work in the market place on a day-by-day basis is a much more difficult task. The reason is that as soon as money is committed to an investment, so is emotion. Every time we review the prices of our investments, we subject ourselves to the impulses of fear and greed. These have the effect of deflecting our judgement away from objective criteria to emotional ones. Of course, common sense dictates that periodic monitoring of a portfolio performance is a necessary part of the investment process, but if we get too close to the market, the tendency is to respond to events and prices instead of carefully laid out criteria. The asset allocation approach as described here makes a valuable contribution to this ongoing psychological battle that all investors have to face. First, the very adoption of the principles of allocation implies the establishment of reasonable investment goals and the employment of a plan. If you make a plan and stick to it, you are far less likely to be sidetracked by the latest news and investment fashion. Furthermore, the process of asset allocation involves a slow but steady rotation of asset classes as evidence of changing conditions emerges. This gradual shift means that the emotional ups and downs will also be less intense because the stakes of any specific change will be limited.
History shows that, with few exceptions, the most successful investors have been those who have concentrated on the long term. Today the media have a tendency to glorify the money managers or mutual funds that have outperformed the pack over the latest quarter. But in reality, near term variations in performance are heavily influenced by chance or by the temporary success of a particular investment philosophy or style. Money managers who specialize in smaller companies are bound to have their performance lifted when these stocks come into fashion. The great temptation is to compare your own performance with the latest investment stars and to reallocate your assets in their footsteps. Studies continually show that, over the long haul, most money managers under perform the market. Perhaps more to the point those that beat the market in one period have a less than even chance of doing it in the next. In reality, success in any venture is achieved at the margin. The tortoise approach implied by a gradual and continuous reallocation of assets will, in the long run, beat the promise of the investment hare of quick and easy profits.
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