Asset Allocation: The Cornerstone of Your Investment Strategy

During the 2008 sell off, stock markets around the world plummeted on average by more than 35% while emerging markets indexes crashed more than 50% on average. Since many investors rely on the stock market to insure their retirement trough their pension funds or IRA, such an event had many disastrous results for those with heavy weight in equities in their portfolios. Was their asset allocation optimal? Possibly not.

But what is a proper asset allocation? This depends mostly on the age, risk tolerance, financial profile and life expectancy of the investor. A general rule of thumb says that 100 minus your age should represent your equity exposure in your retirement portfolio. For example, I'm 40 years old so the equity portion of my retirement portfolio should be around 60%. While this simple might not look very scientific, it does give an honest landmark.

Does a sound asset allocation matter so much? Wouldn't you be better off if you did some decent stock picking to do the work? What about market timing?

It might be a shock to you but according to a study made by Brinson, Singer, Beebowery in 1991, 91.5% of a portfolio volatility is explained by it's asset allocation. In other words, to make sure that your portfolio meets your risk tolerance and, consequently, your expectations of returns, you must concentrate the majority of your efforts on a sound asset allocation.

The volatility of a portfolio is explained by:

Asset allocation 91.5%

Stock selection 4.6%

Market timing 1.8%

Other factors 2.1%

Asset allocation got more complicated in the recent years because of the thousands of exchange traded funds (ETF) that offer a vast selection of asset classes such as:

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• Geographic areas (United States, Europe, Emerging markets, etc.)
• The different asset classes (Equities, Bonds, Real estate, Commodities, etc.)
• Different sectors (Energy, Financial Institutions, Healthcare, etc.)
• Different management styles (Value vs Growth)
• Etc.

With a choice so vast, a lot of investors could get lost very easily. Let's keep it simple; a complete diversification across the 2 major asset classes, bonds and stocks, could very be done with only 2 ETF's:

Equity portion of portfolio: Vanguard Total Stock Market ETF (VTI)

Bond portion of portfolio: iShares Barclays Aggregate Bond (AGG)

Just make sure you allocate properly your assets between stocks and bonds, and you should do fine in you investments.