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Asset Allocation

Investing

In my earlier blog I talked about asset classes. Next, how do you determine what percentage of each asset class belong in your portfolio, i.e. asset allocation.

Why Is Asset Allocation Important?

In simple terms, your asset allocation determines how much risk or volatility you will have in your investments. For example, an investment in a Certificate of Deposit (CD) will have a different investment return than an investment in a Large Cap Value stock. Furthermore, the interest payments and account balance on the CD are guaranteed, the same is not true for the Large Cap Value Stock.

How to Set Your Asset Allocation.

Typically, asset allocation is set as a percentage to each asset class. For example:

  • 50% cash
  • 50% stock

There are unlimited possibilities to determine the asset allocation for your portfolio, I find there are fundamentally three different strategies.

  1. Fixed Percentage Model - In this strategy each asset class is given a fixed percentage and used for all investments. The percentages never change. Very simple.
  2. Risk Based Model - The investors risk tolerance is determined, usually by the use of questionnaires. Investors with a higher level of risk tolerance will have larger percentages in stocks and less in bonds or cash. Investors with a low risk tolerance will have just the opposite, higher percentages in cash and bonds, lesser percentages in stocks.
  3. Age-Based Portfolios Model - Based on the investors age the asset allocation is determined. Younger investors have larger percentages in stocks and less in bonds or cash. Older Investors will have just the opposite, higher percentages in cash and bonds, lesser percentages in stocks. As investors age (no I haven't found a way to get younger) the portfolio will change to less stocks, more bonds and cash.

At Jerry J Davis CPA PC we use a combination of Risk and Age Based Models. We send our clients a Riskalyze questionnaire and compare their responses to their goals and age-based models. The combination of both models helps us design a portfolio that matches the investor.