Mike Brandone

What is asset allocation? It’s an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate, and derivatives. With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the sidelines.

There is so much that goes into how we allocate assets today, our discussion will focus on risk tolerance and rebalancing. We covered risk in July but we need to review this topic if we are to understand asset allocation. The risk-return tradeoff is at the core of what asset allocation is all about. It's easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest "potential" (stocks and derivatives) isn't the answer. What separates aggressive and return-hungry investors from successful ones is the ability to weigh the difference between risk and return.

Let’s break down two types of allocation, Strategic Asset Allocation and Tactical Asset Allocation. Strategic Asset Allocation is a portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation. Tactical Asset Allocation is an active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors.

If you are a buy and hold type investor Strategic Allocations may work best for you. If you like to actively trade investments Tactical Allocation is the better way to go. Another strategy to understand is Modern Portfolio Theory. One of the most important and influential economic theories dealing with finance and investment, Modern Portfolio Theory was developed by Harry Markowitz in 1952. Modern Portfolio Theory says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket. Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's portfolio.

The final component I want to cover is diversification. Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others.

We use a combination of both MPT and diversification to assist our clients in gaining the most effective investment portfolio based on their time line and risk tolerance. We have just scratched the surface of asset allocation in this article. If you are looking for a portfolio that will fit your needs, we will be happy to help.

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Michael Brandone, CLU, ChFC, CFP is a financial Services professional with over 25 years experience in financial planning. Mr. Brandone owns Horizon Financial Services a full service financial planning agency in Del Mar CA, He also owns Vue Insurance Services an Insurance brokerage firm in Del Mar, CA. To contact Mr. Brandone e-mail him at mbrandone@torreypinessecurities.com or call 858-259-0131, ext 313. Securities and Advisory Services offered through Torrey Pines Securities, Inc a member of FINRA.