Developing a blueprint is an essential part of any construction project. The contractor needs to have an agreed upon road map to guide his efforts. Where should the support beams be placed? How much materials will be needed for the size of each room? All these answers unfold as the blueprint is created, and it serves as guidance to complete the job at hand.
Similarly, an asset allocation plan is meant to guide an investor’s efforts in building his portfolio. It is a road map of how and when to invest. Simply put, there are 3 basic building blocks of every asset allocation: stocks, bonds, and cash. Stocks have the best returns over time but come with inherent risk. Bonds are generally less volatile, but they can produce more modest returns. Cash is leveraged as a safety net or for income purposes during retirement. Deciding on the percentage to allocate to each category (and sub-categories) can seem overwhelming at first, but with education and assistance, the answers can unfold. There are several factors to consider when creating your asset allocation blueprint; yet the initial work to establish your blueprint is well worth the benefits that can come from a well-developed plan.
Investing is not one size fits all. An asset allocation plan should take into consideration your goals, risk tolerance, and time horizon – all of which are unique to you. It is important to start by defining the purpose for your investment. For example, are you investing in a 401k account deferred for retirement? If so, how close are you to retirement age? A 30-year-old with a 401k may want to take on more risk in the stock market because of his longer time horizon. However, a 60-year-old approaching retirement in a few short years may not want to risk his nest egg in more equities and instead could invest for protection by owning more bonds. Diversification is crucial to the success of any asset allocation plan (you should rarely ever be concentrated in one type of investment), but the weighted decisions (more stocks vs. bonds) should be made according to your specific goals and comfort level.
Benefit from a plan that is easy to understand and implement. Once you have a road map in place, it is easy to see your action plan unfold. By comparing your “target” allocation to what your “actual” allocation is – you can determine what steps you need to take to “rebalance” or adjust your investments. For example, if your model calls for 60% invested in the stock market yet your actual allocation shows only 50% of your account in stocks, you would be prompted to exchange 10% of your bonds or cash for stocks. Analyzing the difference between your target allocation and your actual investments periodically can keep your accounts in line with your goals and keeps the guesswork out of your investments. The concept of re-balancing also compels you to tame a profit. By selling the winners and buying the lower priced “losers,” you capture profits incrementally.
Keep emotion out of your investment decisions. One of the biggest benefits to following an asset allocation plan is that it keeps you from making reactive investment decisions. “Buy low, sell high” is a natural order that can occur when you adhere to your allocation. If the equity markets are high and your stocks are over-valued, your allocation should tell you to sell and rebalance. One of the biggest mistakes you can make as an investor is letting your emotions dictate your actions. Committing to your model and remembering the goals associated with that model will help you keep a cool head during tough times.
Creating an asset allocation is an important step in becoming a responsible investor, and it should not be taken lightly. For this reason, it can be very helpful to partner with a CFP professional to develop and implement your allocation successfully. Just as a contractor knows the intricacies of structural layout and design, a CFP can help you navigate the complexities of building an enduring and successful blueprint.