Friday, December 21, 2007

Word o' the Day: Asset Allocation (ABC's of Financial Planning)

Well, today's word is actually a phrase, but just play along, ok?

Asset allocation is the process by which you (should) decide where to invest your money. Research indicates that something like 90% of investment returns are determined by asset allocation - i.e., being in the right type of asset, rather than security selection, i.e., the individual stocks or bonds you bought. Investments are placed into "classes" based on inherent characterisitcs. It's akin to your grade school teacher having you line up by height, or calling roll alphabetically by last name - she (they were almost always "she", right?) was classifying you by a common characteristic.

For example, stocks are classified as "Large Cap", "Mid Cap" and "Small Cap" and then further into "Growth" or "Value", etc. So you get further refinement into "Large Cap Growth", "Large Cap Value", etc. "Cap" refers to Market Capitalization which is the number of shares of the company times the price per share. It is a measure of the size of a company. A good example of a Large Cap company is ExxonMobil (symbol XOM) the largest U.S. corporation as measured by market capitalization, currently at $510 Billion. Stocks are classified according to their market cap because the stock of companies of similar market size exhibit similar behaviors. Kind of like your grade school teacher assigning detention to "everyone in the back row" based on their (similar) classroom behavior.

Here's a list of some asset classes:

Stocks
Large Cap Growth/Value/Blend or Core
Mid Cap Growth/Value/Blend or Core
Small Cap Growth/Value/Blend or Core
International Growth/Value
Foreign Growth/Value
Bonds
Investment Grade Bonds
High Yield Bonds
Corporate Bonds
US Treasury Bonds
Mortgage-backed Bonds
Real Estate
Real Estate Investment Trusts - U.S. and Foreign
Commodities
Precious Metals
Industrial Metals
Agricultural Products
Oil
Natural Gas
Cash
Money Market Funds
Bank CDs
US Treasury Bills

And the list goes on and on.

The theory of asset allocation is based on the benefits of diversification. The basic tenet of diversification is "Don't put all your eggs in one basket". Pretty profound, huh? Spread them around. The more baskets (asset classes) you have eggs (investment positions) in, the better your chances of a positive return. At the same time, diversification reduces risk through a mechanism called "correlation" - something we'll talk about at another time.

Many investors think they are diversified because they own stock in several different companies. What they don't realize is that those stocks might be all in the same asset class e.g., Large Cap Growth. They are practicing security selection ("I'm going to buy this stock because I think it's going up.") , not asset allocation.

Smart investors (since you are reading this, you are a "smart investor") use asset allocation to design their investment portfolios. A good financial planner can provide you with the tools.

Since it is a holiday weekend, class is dismissed and as a special gift, no homework is being assigned. Extra Good News: December 22nd is the Winter Solstice - from here on out the days get longer!

Questions? kimm@sweetwaterinv.com

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