I keep reading tons of stuff about asset allocation and how you need to diversify your investments. Is it really that big of a deal?

In short, just starting a Roth IRA or a 401(k) or an investment account isn’t enough. If you merely open that account, pick a few default investments, and start throwing money at it, you’re doing far better than the average bear, but you’re still leaving money on the table.

The truth is that you have to put at least a bit of care into allocating your investments. Here’s why.

I’m going to use a very simple example. Let’s say your portfolio is made up of nothing but stocks and bonds. In order to represent stocks, I’ll use the very broad-based Vanguard Total Stock Market Index (VTSMX), and I’ll use the broad-based Vanguard Total Bond Market Index (VBMFX) to represent bonds.

Over the last year (September 1, 2007 to August 31, 2008), the bond index returned 5.66%, while the stock index returned -10.05%.

Over the last five years (September 1, 2003 to August 31, 2008), however, the bond index returned 4.50% annually, while the stock index returned 7.71% annually.

Let’s look at six different allocations over the last year. If you had $10,000 and invested it on September 1, 2007…

… and you put 100% of it into stocks and 0% into bonds, you’d have $8,995 in the account.
… and you put 80% of it into stocks and 20% into bonds, you’d have $9,309.20 in the account.
… and you put 60% of it into stocks and 40% into bonds, you’d have $9,623.40 in the account.
… and you put 40% of it into stocks and 60% into bonds, you’d have $9,937.60 in the account.
… and you put 20% of it into stocks and 80% into bonds, you’d have $10,251.80 in the account.
… and you put 0% of it into stocks and 100% into bonds, you’d have $10,566 in the account.

Just over the last year on a $10,000 investment, different asset allocations amounted to $1,571. That’s a lot of money to leave on the table.

Lest you think this is just an indictment of stocks, let’s look at the five year scenario. If you had $10,000 and invested it on September 1, 2003…

… and you put 100% of it into stocks and 0% into bonds, you’d have $14,497.07 in the account.
… and you put 80% of it into stocks and 20% into bonds, you’d have $14,090.02 in the account.
… and you put 60% of it into stocks and 40% into bonds, you’d have $13,692.97 in the account.
… and you put 40% of it into stocks and 60% into bonds, you’d have $13,275.92 in the account.
… and you put 20% of it into stocks and 80% into bonds, you’d have $12,868.87 in the account.
… and you put 0% of it into stocks and 100% into bonds, you’d have $12,461.82 in the account.

Over that timeframe on a $10,000 investment, different asset allocations amounted to $2,035.25. Again, that’s a lot of money to leave on the table.

This actually illustrates another point very well: the closer you get to the time when you want to cash in your investments, the safer you want to get with those investments. Traditionally, stocks are very volatile (ranging from -15% to 20% annual return), while bonds are pretty stable (returning 4-8% consistently). For example, over the short term (as shown in the first example), the stock market happened to be in the midst of a downturn, so stocks were pretty awful over that one year period. This isn’t a risk that you want to take, so if you’re getting close, you should move your investments into safer and more stable places like bonds so that you don’t lose a chunk of your investment on the home stretch.

On the other hand, if you’re a long way from your cash-in date, stocks usually return better than bonds over that longer haul, as illustrated in that five year example. While having your money in bonds would have returned you a decent return, having all of your money in stocks over that period would have earned you $2K more on a $10K investment.

Obviously, there’s a balance between these two opposing forces, and that’s asset allocation. Obviously, it can get very complex when you start throwing in other asset classes (real estate, commodities, etc.) and also include the fact that different people have different beliefs on where these markets will go.

I like to think of asset allocation as being like the rabbit hole in Alice in Wonderland - the deeper you go, the more confusing it can get.

So how do you know how to allocate? Thankfully, most retirement plans offer a series of funds with names like “Target Retirement 2035″ and “Target Retirement 2045.” These funds automatically do all of this legwork for you, so if you’re not confident with what you’re doing, such funds are a pretty reasonable bet over the long haul.

LazyIf you’re investing outside of a retirement fund, I’d strongly recommend reading The Lazy Person’s Guide to Investing by Paul Farrell, which singlehandedly taught me almost everything I know about asset allocation. As we move towards investing for our future house, I’ll be using that book as a guide in setting up a simple and easy-to-understand portfolio for myself.

In sort, asset allocation is important, but don’t let yourself get too stressed out about it. Use tools like target retirement funds in your retirement accounts to make it easy, and use excellent resources like The Lazy Person’s Guide to Investing for your other needs.

 

 


The Simple Dollar chronicles a man's road to recovery from "total financial meltdown." As author Trent Hamm puts it, "The Simple Dollar is a blog for those of us who need both cents and sense: people fighting debt and bad spending habits while building a financially secure future and still affording a latte or two." We'll post a couple of entries a week, but you can check out his writing daily at www.thesimpledollar.com