c. Asset Allocation: Asset allocation is the process of determining how much you will invest in each specific asset class in your portfolio. Research has shown that the decision of how to allocate your assets is the most important factor affecting your portfolio’s performance (see Robert G. Ibbotson and Paul D. Kaplan, “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?”, Financial Analyst Journal, January/February 2000, pp. 26-33). As you write this section of your investment plan, you should answer these questions:

How much will you invest in each asset class?

What percentage of your total investments will you invest in each asset class?

What is the minimum allocation of funds you will invest in an asset class at any point in time?

What is the maximum allocation?

What is the target allocation?

Your target asset allocation will probably vary throughout your life. Again, the younger you are, the more likely it is that you will be willing to invest in riskier asset classes. Likewise, the older you are, the less likely it is that you will be willing to invest in riskier asset classes. Younger investors usually have more higher-yield, riskier equity assets (such as small-capitalization stocks and international stocks) and fewer lower-yield, safer assets. Older investors usually have fewer risky equity assets and safer assets (such as government bonds and corporate bonds).

In general, the first decision you should make when you are determining your asset allocations is between stocks and bonds. One time-tested way to decide how much you should invest in bonds is to use your age as the percentage for the allocation. The logic behind this starting point is that the older you are, the more you should invest in bonds because bonds are less risky than other investments. The remainder of your portfolio would be allocated to equities.

The second decision you should make when you are determining your asset allocations is understanding your risk tolerance. I recommend that you take a number of different risk-tolerance tests to help you decide how to make allocations in your portfolio. One example of a risk-tolerance test is found in Learning Tool 16: A Risk-Tolerance Test in the Learning Tools directory of this website. Based on the results from this test, you may either decide to increase your equity allocation above the time-tested approach above if the test indicates that you are an “aggressive” investor or reduce your equity allocation if the test indicates that you are a “conservative” investor. The amount that you increase or reduce different allocations should be based on your individual tolerance for risk.

After you have decided on your portfolio’s allocations, you should add different types of stocks and bonds to deepen your portfolio. You might add some small-capitalization stocks or some international stocks if you want to take on more risk. Or you might add some federal tax-free municipal bonds or state tax-free Treasury bonds if you want to reduce the risk of your portfolio. You can then broaden your portfolio by adding additional asset classes, such as real estate, emerging markets, and inflation-linked bonds.

Once you know the asset classes you want to invest in, it is important that you decide on a minimum allocation, maximum allocation, and target allocation for each asset class. A minimum allocation is the minimum amount you want to have invested in a particular asset class at all times. Having a set minimum allocation preserves diversity in your portfolio. Diversification is an important tool for reducing risk. A maximum allocation is the maximum amount you want to have invested in a particular asset class at any point in time. Since your allocations will change over time, reaching your maximum allocation will be a signal that it is time to rebalance your portfolio back to your target allocation. Finally, your target allocation is your ideal allocation, based on your current expectations and the current market conditions.

When you are determining minimum, maximum, and target allocations, you should take into account where you want to be throughout your entire investing life. It is likely that you will have to make different allocations for the different stages of your financial life cycle—for example, newly married, kids in college, retirement, and so on.