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An asset allocation primer
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November 26, 2001: 4:50 p.m. ET
Here's a step by step guide to building a diversified long-term investing portfolio.
By Walter Updegrave
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NEW YORK (CNN/Money) - When the market's being knocked as it's been over the past 18 months, you may be tempted to move out of sectors that have been vulnerable and into ones that are thriving. More often than not, however, such moves backfire, and you'll end up getting out of the slumping sectors after the damage is done and into the hot ones after prices have already gone up.
A better approach: Concentrate on keeping your portfolio broadly diversified among a variety of asset classes and types of stocks, so at least some portion of your portfolio can be cruising along nicely even if other parts are getting creamed.
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 BUILD YOUR ASSET ALLOCATION
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Calculate your weightings in stocks and bonds
Get a breakdown by size, style and sector
The longer your time horizon, the higher the stock weighting
Be careful of company stock in your 401(k)
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The first step toward finding the balance of assets that will help you achieve your goals is to find out exactly how your money is invested now.
Start by looking at your list of investments. Calculate how much of your portfolio is allocated to stocks, including stock funds, and how much to bonds, and bond funds. Now you can move on to finer distinctions in the stock portion of your portfolio.
You'll want to get a breakdown of your investments by size, style and sector. By size, you're looking at the market capitalization of the company, meaning large-cap, mid-cap or small-cap. The style is either growth or value. Growth companies have rapidly rising earnings, while value companies are cyclical. Finally, you'll want to sort your holdings by sector -- energy, financials, technology, utilities and so on.
Unless you happen to be on a first-name basis with the managers of the funds you own, you're not going to be able to come up with this kind of finely calibrated breakdown on your own.
But you can go to an online portfolio-analysis calculator to get a percentage breakdown of your portfolio's overall stockholdings by market cap, investing style and 10 industry sectors.
Stocks vs. bonds. Once you know the characteristics of your portfolio, you can begin adjusting your allocations to reflect the goals you've outlined and your tolerance for risk. Start by figuring out how much of your portfolio should be in stocks, since your stock/bond mix will largely determine what returns you earn over time and how much your portfolio's fluctuations follow the ups and downs of the market.
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The longer your time horizon, the higher your stock weighting will be. | |
The farther away the goal you're investing for, the more of your money should be in stocks. After all, over long stretches stocks tend to outpace bonds by a wide margin. Even taking into account the stock market's dismal performance over the past two years, stocks still gained an annualized 12.8 percent for the 10 years through Oct. 31, while bonds gained just 7.9 percent.
So if you're investing for a retirement that you won't reach for a decade or longer, you want to have most of your money -- say, 70 percent to 85 percent -- in stocks. Bonds, on the other hand, provide stability. While stocks declined 24.9 percent over the past 12 months, bonds gained 14.6 percent. So if you're investing money that you'll need within three to five years, say, for a house down payment, you'll want to keep 60 percent to 70 percent or so of those assets in short- and medium-term bonds. That way, you won't have to worry about a stock market slump socking you with big losses just before you need your money.
Small vs. large. After you've settled on a stock/bond mix, you want to have large and small stocks represented in your portfolio. Over long periods, small-caps can generate returns roughly two percentage points a year higher than large-caps, so owning them can certainly boost your long-term gains. Tilting your mix too far toward small stocks, however, can dramatically increase the volatility of your portfolio, since small-caps also tend to fall farther and faster during most market downturns. So the more you crank up your small-stock holdings beyond 10 percent to 15 percent--which is about the percentage small stocks represent in the overall stock market--the more your portfolio will fall compared with the market during stock downturns.
Growth vs. value. You also want to have both growth and value shares in your portfolio, since their returns tend to seesaw (value beat growth in the early '90s; growth trounced value in the mid-to-late '90s). You can certainly make a case for slightly overweighting either style in your portfolio. Research shows that value tends to outperform growth over periods of 25 years or more. Growth stocks generate more powerful bursts of returns, although they do so at the cost of higher volatility. But don't stray too far from a fifty-fifty split, which is roughly the growth-value mix in the U.S. market.
Industry weightings. Similarly, you should use the market as a rough guide when it comes to industry sectors. If you've got 20 percent of your holdings in financial stocks and the market allocation is 18 percent, you're not courting disaster. But if you have, say, 50 percent of your money in tech vs. the S&P 500's recent weighting of about 20 percent, then you should be prepared to steel yourself against some sizable swings in the value of your portfolio.
International vs. domestic. As for overseas holdings, there's no consensus on how much individual investors should have. Given the lackluster performance of international shares during much of the '90s, some experts, including Vanguard Funds founder John Bogle, contend that you don't need international investments at all. On the other hand, ignoring the abundance of outstanding overseas companies doesn't seem to make sense. That's why many online asset-allocation tools, including CNN/Money's, typically recommend putting 10 percent to 20 percent of your portfolio in international stocks or funds.
Your job vs. your portfolio. As you're fine-tuning your allocations, you'll also want to consider another asset you may not think of as part of your investment portfolio: yourself. In an economic sense, you are as much an investment asset as any stock or bond, since you generate income during your career that amounts to a return on what economists call your "human capital."
And as much as possible, you want to make sure your human capital adds to, rather than detracts from, the diversity in your portfolio. So, for example, if you work for a bank, your economic wherewithal is already riding on the prospects for the financial industry. You might then consider lightening up your holdings in that area and even possibly adding to your stake in industry sectors that tend to react differently to economic forces than banks. Energy stocks, for example, tend to do well when interest rates rise, sparking fears of inflation. Banks, on the other hand, usually perform better when rates are low.
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Research shows that value tends to outperform growth over periods of 25 years or more.
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You should also try to adjust your allocations to reflect any sizable holdings in your company's stock. On the one hand, you may feel comfortable bulking up on your employer's stock since you're probably well attuned to the company's financial health. Still, you're taking on extra risk by having both your job and your investment portfolio dependent on one company's prospects. If your employer's business runs into trouble, you could end up getting laid off at the same time that your company's stock hits the skids.
To avoid such a double whammy, limit your company stockholdings to 20 percent of your overall portfolio. If you don't want to or can't pare back below that level -- some 401(k) plans match employee contributions in company stock that can't be transferred -- then you should at least consider tweaking other parts of your portfolio.
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Avoid too much company stock in your 401(k). You're taking on too much risk having your job and your nest egg dependent on one company's financial health.
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If you work for a large technology company and have, say, 30 percent of your 401(k) invested in company stock that you can't move, then you might want to trim your holdings of tech and other large-cap growth stocks in your 401(k) and increase your holdings of small-cap value shares. If you don't have that flexibility within your 401(k), you could make a similar adjustment elsewhere in your portfolio. This advice, by the way, applies to any large position in the stock of one company, whether or not it's your employer, since concentrated bets can increase the risk level of your portfolio.
Up to this point, we've been using the phrase "your portfolio" as if all your investments are held in one all-inclusive pot--and that's how some of us track our money. But others create discrete portfolios for different financial goals--one for a child's education fund, another for tax-deferred retirement savings and yet another for retirement assets in taxable accounts. When analyzing your holdings, you want to use both approaches. Certainly, creating a separate asset mix for each individual portfolio will make it easier for you to manage your investments in cases where you have several goals each with different time horizons.
On the other hand, by looking at how all of your allocations work together as part of one large portfolio--which, in reality, they are -- you're more likely to spot areas in which you are too heavily weighted, or ones you're neglecting. So, for example, if you find you have a lot of growth funds in your taxable account but you're reluctant to sell holdings because it would generate taxable gains, consider selling growth funds in your 401(k) or IRA, where there are no tax consequences, and then plowing the proceeds into value funds.
This article originally appeared in the December issue of MONEY magazine. 
* Disclaimer
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