Asset Allocation: The key to constructing an optimal portfolio

Choosing your asset allocation might be the most important investment decision you’ll ever make. The bad news is, no universal mix of stocks, bonds and cash is right for everyone. The good news is, you can tailor your portfolio to your specific circumstances and needs. Let’s start with the basics:

What is asset allocation? Asset allocation is the apportioning of investment dollars among asset categories such as stocks, bonds and cash equivalents. Some investors also hold secondary asset classes such as real estate, precious metals and collectibles. Your allocation is the percentages in which you divide your total portfolio into each category.

Why is asset allocation important? Studies* show that decisions about asset allocation can have a far greater impact on investment results than specific stock, bond or mutual fund choices. The idea is that because the returns of different asset classes are not perfectly correlated—that is, they don’t move up and down at the same time—the overall risk of a portfolio is reduced by diversification. Simply put, you don’t keep all your eggs in one basket. Diversification, incidentally, is important within asset classes as well as among them.

What are the three major asset classes? Stocks are ownership shares in corporations. Historically, stocks have had the greatest risk and highest returns; investors who have held stocks through market ups and downs over long periods of time generally have achieved strong positive returns. Bonds are IOUs from corporate or government borrowers to pay interest and principal on debt. They generally are less volatile than stocks but offer lower returns. Cash and cash equivalents—such as savingsdeposits, certificates of deposit, treasury bills and money market accounts—are the safest of the three major asset classes, but offer the lowest returns. One risk of holding cash is that inflation will erode its value over time.

How do I find the right asset allocation for me? It’s a very individual process. A qualified financial professional can help. Key factors to consider are your investment goals, time horizon and tolerance for risk. Each of the three major asset classes has its own historic risk/reward characteristics. One rough guideline is to invest one’s age in bonds; that is, a 30-year-old person would invest 30% in bonds, a 50-year-old would invest 50% in bonds. He or she might hold cash equivalents sufficient to cover living expenses for six months to a year, and invest the rest in stocks.

Why change my asset allocation over time? It has to do with risk and reward. The 30-year-old investor might have a longer investment time horizon in which to ride out the ups and downs of the stock market—and therefore invest more in stocks. The 50-year-old, with a shorter time horizon, might seek to decrease portfolio volatility and therefore tilt toward bonds, which generally are considered safer. A final word: It’s important to re-balance one’s portfolio every year to ensure your asset allocation remains on track.

Karpus Investment Management brings proven expertise in asset allocation. Each client portfolio is individually managed. As well as determining the optimal asset allocation for you, KIM adds another level of safety and performance through disciplined shifting of allocation weightings in response to anticipated market trends. For example, KIM reduced client exposure to stocks prior to the market downturn of 2008.

*For example, Brinson, Hood, and Beebower: "Determinants of Portfolio Performance," Financial Analysts Journal (1986, 1991).