The distribution of assets to balance risk and reward is the most important principle of investing. A little wisdom makes a huge difference in the return on investment.
A lady named Kimberly came to me, and she was visibly upset. Her husband Ed had an IRA with $100,000, but he had kept it in a money market at .5% during five years the market had gained 10 to 16% each year. They were both about 35 years old.
Dozens of times, she had suggested that he move his money to more productive instruments, and finally, he agreed to meet with me. I explained asset allocation, and they both felt much more comfortable about investing the money.
Inflation is a Big Risk
They understood inflation was a big risk to their future, but properly allocating their assets in the market would help them balance risk and return. When I showed them the math, they were stunned.
Here’s what I explained: If they kept that $100,000 in the money market (cash) account at .5% from age 35 to age 65, the account would be worth only $116,140. By investing their 401k into a diversified family of mutual funds with an expected return of 8% compounded annually, the amount would jump to $1,006,265!
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Kimberley and Ed almost fought each other to see who would sign the papers to move the funds.
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Asset allocation needs to factor in these elements:
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Your risk tolerance, which determines how aggressive or conservative your investments will be,
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The time horizon for achieving your stated goals, such as college education for a child in 2 years and retirement in 35 years, and
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The market dynamics of cash, bonds, equities, and real estate and their relationship to one another to maximize returns while minimizing risk.
Three Big Factors
Three factors determine the performance of your portfolio:
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Asset Allocation,
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The Selection of Assets (Stock Picking), and
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Market Timing
In a ten-year study of ninety-one large corporate pension plans in the United States, the authors of an article in Financial Analysts Journal found that…
94% Of Performance Was Determined By Asset Allocation.
Investment selection accounted for only 4%, and market timing was responsible for 2%.
The metaphor I use to explain asset allocation is balancing a tire for high speed driving. When I was a mechanic, and a customer came to my shop because the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rubber from uneven wear.
Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counterbalance the wheel.
We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.
Asset allocation balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the distribution of assets.
Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution.
But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.
