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What the Heck is Asset Allocation

By JLP | December 14, 2005

Basically, asset allocation is how a person “allocates” or divides up their investable assets among different asset classes. It can be as simple as dividing a portfolio in half and putting 50% in a stock index fund and 50% in a bond fund. It can be taken a step further by taking the stock portion and dividing it up among large-caps, mid-caps, and small caps and dividing the bond portion among bonds with different maturies.

Just like having a financial plan, it is important to have an asset allocation plan (also known as an investment plan). Why? Because without an investment plan, people tend to buy what they shouldn’t buy when they shouldn’t buy it! I know a lot of people who move their 401k money into whatever fund performed best LAST YEAR! The chances of that fund performing best THIS YEAR are pretty slim. But, people do it anyway.

The importance of asset allocation can be best seen with an example. Suppose a person has a written asset allocation plan that says that they will invest in the following manner:

25% or $25,000 – Large-Cap fund
25% or $25,000 – Mid-Cap fund
25% or $25,000 – Small-Cap fund
25% or $25,000 – Bond fund

Let’s say in this particular year, the different funds had these rates of return:

Year 1

+10% – Large-Cap fund
+08% – Mid-Cap fund
+15% – Small-Cap fund
-02% – Bond fund

The portfolio would look like this:

(the formula for calculating a return for one year is: Beginning Amount X (1 + the rate of return expressed as a decimal)

$25,000 X 1.10 = $27,500 Large-Cap fund
$25,000 X 1.08 = $27,000 Mid-Cap fund
$25,000 X 1.15 = $28,750 Small-Cap fund
$25,000 X 0.98 = $24,500 Bond fund

Total Portfolio value at end of year 1: $107,750 or a 7.75% rate of return.

Most people would probably want to sell all of their bond fund and put it all in the small-cap fund (since it went up the most!). That’s human nature. Nobody likes to hold an investment that seems to be losing money. However, suppose the next year, the fund’s returns were like this:

Year 2

– 05% – Large-Cap fund
+03% – Mid-Cap fund
– 20% – Small-Cap fund
+05% – Bond fund

At the end of year 2, the portfolio would like this:

$27,500 X 0.95 = $26,125 Large-Cap fund
$27,000 X 1.03 = $27,810 Mid-Cap fund
$53,250 X 0.80 = $42,600 Small-Cap fund

The portfolio would be worth $96,535 (for a one year LOSS of 10.41%!)

Finally, had this person stuck with their asset allocation plan and reallocated so that 25% was in each of the 4 funds, they would have only had a loss of 4.25% instead of 10.41%:

$26,937 X 0.95 = $25,950 Large-Cap fund
$26,937 X 1.03 = $27,810 Mid-Cap fund
$26,937 X 0.80 = $21,550 Small-Cap fund
$26,937 X 1.05 = $28,284 Bond fund

The portfolio would be worth $103,170 (for a one year loss of 4.25%, which is MUCH better than the 10.41% loss in the above example!).

I must mention one important note: Asset Allocation does not mean that a portfolio will get the best return in any one year, instead it helps smooth out returns.

I hope this helps! Until next time…

Topics: 401(k), Asset Allocation, Investing | 3 Comments »

3 Responses to “What the Heck is Asset Allocation”

  1. Investing Intelligently Says:
    December 16th, 2005 at 6:38 pm

    Asset Allocation and Rebalancing

    Interesting example of asset allocation and rebalancing in this article, “What the Heck is Asset Allocation.”
    He illustrates two cases (over 2 years):

    Case 1: Investing $100,000 in 4 different mutual funds (large-cap, mid-cap, small-ca…

  2. Jeff Says:
    June 20th, 2006 at 10:23 pm

    Great stuff on asset allocation. This is such an important part of managing a 401(k) effectively. Unfortunately, recent studies show that about 80% of account holders make no trades to their account over a 2-year period. For those who don’t have the time to manage their own account, one possible solution is personal 401(k) management, where an expert manages someone’s account on their behalf.

  3. Are you making these disastrous financial mistakes? | On Financial Success Says:
    May 3rd, 2008 at 7:50 pm

    […] your tolerance for risk. Take a step back, re-assess your risk tolerance, and develop a reasonable asset allocation that allows you to own everything. Your portfolio will fluctuate less while still benefitting from […]