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What is Asset Allocation?

By Charles Hopkins Published 05/24/2007 | Finance

Asset allocation is not a matter of owning several stocks or several mutual funds. You need to be holding assets in different sectors of the market. When talking about mutual funds they are generally divided into the sectors of large cap, small cap, international and fixed income. Cap is short for the word capitalization, how much capital a particular company has. A large cap company might for example have 5 billion in capital while a small company may have only 50 million.

You can further divide these sectors into value and growth. Value stocks are ones that are not performing up to par. Maybe there was some bad news about the company that caused the stock price to decrease, but overall the company is believed to be a good company. Generally these are large, well established companies where there is normally not a lot of volatility in the stock price, but are currently selling below their value. Growth stocks on the other hand are expected to be increasing in size at a rapid pace, maybe because of a new product coming on the market or because the company has developed a new technology. This company is expected to get bigger. It is important to note that while one financial analyst may consider a stock a value stock, another financial analyst may consider that same stock a growth stock.

The purpose of asset allocation is to reduce the overall risk of your portfolio while achieving a good rate of return. The point is that you have assets in all sectors all the time. Today and for the next six months it may be that international funds are going to be performing better than usual. Or maybe it will be small cap growth stocks are performing better. Do you know which sector of the market is going to be the "hot" sector for the next several months? By having your investment diversified into the different sectors you are going to have part of your money in that hot sector. No trying to time the market and figure out where the best place to be is next.

How much you put into each sector of the market will vary with the level of risk that you are willing to accept. As a 20-something you might be willing to put 40% into international stocks, which are considered more volatile while as a 70-something you may only put 10% into an international fund. You still need asset allocation at every age. There are numerous programs available that can help you determine the best allocation for someone of your age and risk level. They can be found on the websites of most mutual fund families.

The key to a good asset allocation portfolio is rebalancing. Say for example that large cap growth stocks have done well in the market for the last six months. If your ideal portfolio is 30% large cap, 25% small cap, 30% international and 10% fixed income you may now have 45% large cap since there has been a run-up in these funds. At the same time small cap funds were doing poorly and now only represent 15% of your portfolio. You need to sell some of the large cap fund and buy some of the small cap fund to bring your portfolio back into balance.

What does this cause? It causes you to sell when a fund is high and buy when a fund is low. This is exactly what you need to do to increase the overall rate of return without increasing the risk of your portfolio. Rebalancing can be done as often as quarterly or as little as once a year. Rebalancing your portfolio more than quarterly is not considered advantageous. The goal is to keep your portfolio at the percentages that you determine when you set the portfolio up. Do not get caught up in the fact that a fund is doing really well and thinking that you should not sell it. How will you feel in six months if the fund is under-performing?

Do not trust yourself to be able to sell when you should? Do not want to be tied to having to remember to rebalance every quarter? Do not want to incur the tax consequences that may result if you are rebalancing in a taxable account? Have only a small amount of money to invest? Invest in one of the many asset allocation funds available. These funds do the allocating and the rebalancing for you. Generally you only need to decide if you want the aggressive, moderate, or conservative allocation fund. These funds may also go by the name of target retirement funds or lifestyle funds. What you are looking for is a fund that invests in all the sectors of the market.