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Asset Allocation: How You Slice Your Pie

By: Investor Solutions

By: Investor Solutions

Have you ever found yourself receiving mountains of statements from custodians for your various investment accounts? You know, you have that Rollover IRA from your previous job, a 401k from your current job, a Roth IRA and maybe even an E*Trade account for you to “play” with. We’ve all been there. With so many accounts all spread out, do you even know what your investment picture looks like? Do you know how your assets are allocated? Investors alike want a portfolio that gracefully weathers the peaks and valleys of the market and gets them the best possible return. After all, we all have dreams of how our golden years will be spent. Read on to learn how you should invest for a more financially secure future.

The most important consideration when creating an investment plan is asset allocation. Asset allocation, in simple terms, is how you slice your investment pie. That is, how much weight you allot to a given asset class. Unlike market timing and stock selection which account for a paltry, 2% and 4% of investment return, respectively, asset allocation accounts for a whopping 94% of how well your investments perform. A properly allocated portfolio will include investments across domestic and international markets, large and small cap equities categorized as both growth and value. Alternative asset classes such as REITs and commodities might also be appropriate.

The first step when creating an investment blueprint is gauging your risk tolerance. Your tolerance for risk will drive the allocation between equities and fixed income. Once this ratio has been determined, you can slice the equity portion of your investment pie among the aforementioned asset classes. In doing so, it is imperative that you look at all of your accounts aggregately. Most investors have more than one type of account. That is, their portfolio may be comprised of retirement accounts (traditional, Roth and rollover IRAs, 401k, etc.) and taxable accounts (individual, joint and trust accounts). For example, you may have a Roth IRA in which you purchase a REIT fund, a Rollover IRA where you invest in an emerging market and commodity fund and an individual taxable account in which you purchase the core funds (i.e., domestic and international, small and large cap, growth and value). For more on asset location, please refer to “Asset Location Is As Important As Asset Allocation” by Richard Feldman, MBA, CFP®, AIF.

Once you have properly assessed your risk tolerance and allocated your assets accordingly, you will want to track the performance of your portfolio. It is important when you review your portfolio return that you do so at the macro level as well. You should not compare the return of your Roth IRA to that of your Rollover IRA or taxable account. These accounts can and usually will have very different returns for the same time period. In fact, they should have different returns. That is because a properly allocated portfolio will be comprised of assets that have less than positive correlation. In other words, the assets do not behave in the same fashion. When one goes up significantly, another may be slightly underperforming. Instead, you should be looking at all of your accounts together and comparing that return to an index or benchmark return of a comparable portfolio. This will give you a true picture of how well you have allocated your assets.

There are many benefits to having one asset allocation plan for all of your investment accounts. These include a reduction in stock overlap, costs and risk and an increase in returns. Stock overlap exists when you own two different mutual funds with the same investment objective (i.e., large cap growth). You may think that by buying more funds within the same asset class you are better diversifying your portfolio. The reality, however, is that you are paying for something that does not have any added benefit and which is potentially exposing you to a greater level of risk. Another important consideration when selecting investments is keeping the costs at a minimum. Expenses come in many shapes and sizes, from front and deferred loads to 12b-1 fees to expense ratios. By choosing mutual funds wisely, you will keep investment costs down and thereby increase your return. Lastly, an appropriate asset allocation will keep the risk of a portfolio at a minimum and increase your return. And isn’t that what we all want, a bigger piece of the (investment return) pie?

The end of year is a great time to evaluate your investment portfolio and make changes for the better. So take some time to review how your assets are allocated to ensure that your portfolio return is commensurate with your risk tolerance and expected return. As always, if you need further guidance, contact your financial advisor.