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Why Asset Allocation Is So Important

By: Mike | Date posted: June 22, 2010 (5:00 am) | Write a Comment (8 Comments)


Over the past months, I have written a few articles about asset allocation and the different asset classes. Knowing the difference between fixed income and equity is the first step as you start on your investing journey. But the next step is even more important, to understand why you need all of this. Can’t you just pick a few stock market indices, build your portfolio and open your account statement in 30 years just before your retirement? If it was so simple, I would not have a job anymore ;-)

A good Asset Allocation helps you sleep at night

I’d say that buying a few stock market indices is not a bad investing strategy if you know what you are doing and are not afraid to see your investments melt by 40% in one year.

So this is why you should use a good asset allocation; to make sure you will never lose 40% in any given year. Before saving the very first penny, an investor is driven by the hope (or financial advisor’s promise) of gain. Their appetite is so violent that the  novice investor forgets about the possibility of losing money. They want to make money, and they want it now.

On the other hand, the harsh side of reality, when a novice investor can lose 5-10% in the span of a month or 2 (during a nasty bear market for example), he starts to panic. “this wasn’t suppose to happen, I was planning to make money from this, he told me that I should average 6%…” blah, blah, blah, whine, whine, whine…

A well balanced portfolio will obviously smooth out the dips and the spikes so you stay closer to this so magical average of 6% all along the way. Having different asset classes, will allow you to protect your portfolio against drastic fluctuations.

A good Asset Allocation makes retirement planning more accurate

When we use 10, 15, 20 years or more of historical data, we notice that a good asset allocation has a much better chance to give you a steady yield. Why? Simply because you are not trying to bet on a single winner. Since you are betting a little bit of money on several horses, you have more chances to win a little bit each year. As it is impossible to predict which asset classes will outperform 1, 2, 3, 4 years down the road, you are better off having more asset classes to make sure you have some winners in your portfolio.

What is a good asset allocation anyway?

By definition, a good asset allocation will be in line with your investor profile. For us mortals, this means that your money will be invested according to 3 questions:

#1 When do you need your money?

The length of time your money can remain fully invested before you need to start withdrawing it.

#2 How much are you willing to lose?

The amount (in dollars or percentage) you are willing to risk (i.e. lose on paper) before panicking.

#3 What do you know about investing?

Your investment knowledge (you would be a fool to invest everything in the stock market without knowing how it works).

Once you know the answers to those 3 questions, you are ready to make a good asset allocation with the help of a financial advisor to accompany you on your investing journey.

image source: blprnt van

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8 Comments
  1. Comment by IntelligentSpeculator — June 22, 2010 @ 6:51 am

    My main question would be, how many differents asset/funds/etf’s do you consider necessary to achieve good diversification?

  2. Comment by Mike — June 23, 2010 @ 12:27 pm

    this is a key question!

    I think you need at least 7 asset classes:
    government bonds
    corporate bonds
    preffered shares
    US stocks
    international stocks
    emerging markets
    ressources

    with such portfolio, you will be in a good position to benefit from most uptrend in the markets. However, this is a very simple portfolio example…

  3. Comment by Neil — June 23, 2010 @ 8:32 pm

    Excellent point. A good retirement investment plan should include a phase during the closing years when the investment allocation is progressively weighted more towards fixed income and away from equity.

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