How Strategic Asset Allocation Can Make You a Better Investor
Oct 31st 2012 1:54PM
Updated Oct 31st 2012 2:00PM
Many financial professionals give the impression that investing is too complicated to pursue on your own without assistance. But with the help of a technique called strategic asset allocation, you can get results similar to or better than what many pros will give you, usually at a fraction of the cost.
How it works
Simply put, strategic asset allocation involves taking your money and dividing it up into several pieces, which you then allocate across different types of assets. Once you've decided on how much of your money will go into each broad asset category, you then drill down and choose individual investments that fit into those categories.
The first step requires two decisions. First, you need to decide what sorts of assets you want to include in your portfolio. Traditionally, asset allocation strategies usually stuck with three major asset classes: stocks, bonds, and cash. But recently, the availability of alternative investment classes like real estate, commodities, and specialized investments in private equity and hedge funds led to many investors broadening their asset allocations to include more complex combinations of assets.
After you decide which assets to include, you must then choose how much of your money to allocate to each asset class. Historically, most professionals recommended higher allocations to more aggressive investments like stocks and commodities early in life, with allocations growing more conservative as you got older. But recently, stock researcher Rob Arnott did analysis that called that conclusion into question, noting that later in life when you have more assets to invest, taking more risk has a bigger payoff when things go well. For many risk-averse investors, the true answer may lie somewhere in between, with a lot depending on how successful you are in accumulating assets and therefore how big a return you need in order to build a big enough nest egg to meet your financial needs in retirement.
Picking the right investments
The second major part of the strategic asset allocation process is to take the allocations you've determined and then buy appropriate investments. Depending on your preferences, this part of the process can be as simple or as complex as you care to make it.
For instance, you can use exchange-traded funds to implement an asset allocation strategy with just a handful of funds. The basic SPDR S&P 500 ETF (ASE: SPY) , combined with a basic bond ETF, a commodity-tracking ETF, and an ETF owning real-estate investments, could give you a very simple but effective portfolio at low cost.
You can also use ETFs to build a more targeted portfolio. For instance, if within the commodity space you think that precious metals are most likely to shine, then using bullion-owning funds Central Fund of Canada (ASE: CEF) or iShares Silver Trust (ASE: SLV) could give you better results than a generic commodity ETF with diluted bullion exposure.
At the other end of the spectrum, choosing individual securities lets you tailor your strategic asset allocation to your exact specifications. In general, the largest and best-known stocks tend to have pretty high correlations to the overall market, so they don't add much in the way of portfolio diversification. But if you truly believe that one particular stock in an industry is likely to outperform others, then ETFs won't give you the results you want. That can be especially important in an area like technology, where leaders like Apple are leaving also-rans Hewlett-Packard (NYS: HPQ) and Dell (NAS: DELL) struggling for direction in a newly transformed world in which mobile devices are increasingly taking share from PCs.
Get in the game
Strategic asset allocation isn't all that exciting, but it will often be more effective in getting your portfolio moving in the right direction than more sophisticated and complex strategies. By getting a basic foundation under your investments, you'll be in a better position to learn and develop your investment knowledge over time.
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The article How Strategic Asset Allocation Can Make You a Better Investor originally appeared on Fool.com.Fool contributor Dan Caplinger owns shares of Central Fund of Canada. The Motley Fool owns shares of Dell. Motley Fool newsletter services recommend Dell. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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