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Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices. Understanding this strategy can be the key to investment success.
Asset allocation means dedicating certain percentages of your holdings to broad asset categories like stocks, bonds, real estate, and cash as a way to achieve your financial goals while managing risk.
This strategy works because these different categories behave differently. Stocks, for instance, offer potential for both growth and income, while bonds typically offer stability and income. The benefits of different categories can be combined into a portfolio with a level of risk you find acceptable.
Asset allocation plans will be different for different investors, but a hypothetical asset allocation might be illustrated like this:
Why is asset allocation a good strategy?
Studies have found that more than 90% of a portfolio's long-term total return comes from being in the right asset category at the right time.1 But since guessing which asset category will do best at a certain time is very difficult, it can make sense to divide your investments among asset categories.
What allocation is right for you?
Asset allocation helps investors balance the returns they want with an acceptable level of risk. Your asset allocation should be based on your investment goals, time frame, and comfort with volatility.
In retirement, you might want to emphasize bonds and cash for income and stability. But don't overlook stocks, because you need to keep up with inflation.
If you won't need your money for 25 years, a financial professional might recommend an asset allocation of 100% stock. That wouldn't mean investing in only one stock. You'd still want your portfolio to be diversified.
After your allocation percentages have been decided for broad categories, you can take asset allocation a step further by diversifying among classes within the categories.
Can asset allocation improve long-term returns ?
Yes. When comparing different investment strategies over the past 25 years, investing across asset categories has delivered higher returns than choosing asset categories based on their previous performance.
Chasing the winners
Investing in previous year's best-performing asset class |
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Chasing the losers
Investing in previous year's worst-performing asset class |
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Allocating among asset classes
Investing evenly across asset classes |
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Source: Morningstar Workstation, 31-12-2007. The returns shown reflect past results and do not predict or represent the performance of any Franklin Templeton Investement Funds. Asset classes are represented by the following indexes: Large-cap stocks, S&P 500 Index; Large-cap growth stocks, S&P 500/Barra Growth Index; large-cap value stocks, S&P 500/Barra Value Index; small-cap stocks, Russell 2000® Index; small-cap growth stocks, Russell 2000® Growth Index; small-cap value stocks, Russell 2000® Value Index; foreign stocks, MSCI EAFE Index; bonds, Lehman Brothers Aggregate Bond Index. Indexes are unmanaged, and you can't invest in them directly. This illustration assumes that these indexes are reasonable representations of asset classes and their returns. However, investment manager performance relative to the different asset class indexes has varied widely during the past 20 years. |
An asset allocation shouldn't be set in stone
While asset allocation eliminates a lot of the day-to-day decisions involved in investing, it doesn't mean you should just "set it and forget it." Reviewing your portfolio regularly with your financial professional to monitor and rebalance your asset allocation is a good idea. This technique can help make sure you stay on track to meet your goals.
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