Beginner's Guide to Asset Allocation, Part 3

This page is Part 3 of a four part Beginner's Guide to Asset Allocation. 
To start at the beginning please go to Beginner's Guide to Asset Allocation, Part 1

How to Get Started with Asset Allocation
Determining the appropriate asset allocation model for a financial goal can be a complicated task. The goal is to pick a mix of assets that has the highest probability of meeting your goal at the lowest level of risk. Some financial experts believe that determining your asset allocation is the most important decision that you'll make with respect to your investments.  Personally, I believe that in most cases, this decision can have a more pronounced effect on your portfolio earnings than the individual investments you buy.

If you understand your time horizon and risk tolerance (see Beginner's Guide to Asset Allocation, Part 1 for a refresher on these terms) and have the time and interest to learn and stay on top of your investments, you may feel comfortable creating your own asset allocation model.  There are many "How to" books and online resources for the do-it-yourself investor.  However, these often discuss general "rules of thumb," which may not appy to you or which are biased towards a particular investment philosophy or product.  Just remember that there is no single asset allocation model that is right for every financial goal or every individual.

You may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future. But before you hire anyone to help you with these enormously important decisions, be sure to do a thorough check of his or her credentials and disciplinary history.  You can read my article How to Choose a Financial Advisor for additional advice as to what to consider.  Financial advisors are compensated in a variety of ways, so make sure that you understand how and how much you are paying.

The Connection Between Asset Allocation and Diversification
Diversification is a strategy that can be summed up in the saying "Don't put all your eggs in one basket." The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.

This sounds a lot like asset allocation, but diversification should occur at two levels: between asset categories and within asset categories.  To diversity within asset categories you need to divide the money in your portfolio among different types of investments within each asset category.

Many investors only use asset allocation as a way to diversify their investments among asset categories. But other investors do not. For example, a twenty-five year-old investing for retirement may be invested 100% in stocks,  or a family saving for the down payment on a house may be invested entirely in cash equivalents.  These could be reasonable asset allocation strategies under certain circumstances. But neither strategy attempts to reduce risk by holding different types of asset categories. So choosing an asset allocation model won't necessarily provide enough diversification to your portfolio.

The key is to identify investments in segments of each asset category that may perform differently under different market conditions.

One method of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. For example, the stock portion of your investment portfolio won't be diversified if you invest in only three or four individual stocks or invest in twenty stocks, but they are all related to the energy industry.
Because achieving diversification can be so challenging and time consuming, most investors find it easier to diversify within each asset category through the ownership of mutual funds. Mutual funds make it easy for investors to own a small portion of many investments because a mutual fund company pools money from many investors and invests the money in stocks, bonds, and other financial instruments. A total stock market index fund, for example, owns stock in thousands of companies. 

However, a mutual fund investment doesn't necessarily provide complete diversification, especially if the fund is narrowly focused by the size of the companies that it invests in or industry.  If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get enough diversification. Between asset categories, that may mean considering stock funds, bond funds, and money market funds. Within asset categories of stocks, that may mean investing in large company stock funds as well as some small company and international stock funds, as well different industries.

Lifecycle Funds
Some mutual fund companies have begun offering a product known as a "lifecycle fund." The goal of a lifecycle fund is to accommodate investors who prefer the simplicity of one investment to save for a particular investment goal, such as retirement.

A lifecycle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its "target date." The investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing. It's easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like "Portfolio 2015," "Retirement Fund 2030," or "Target 2045."

Congratulations!  You're almost done with the Beginner's Guide to Asset Allocation.
Only one more: Beginner's Guide to Asset Allocation, Part 4