Simple Portfolio-Building Plan

We talk and write a lot about the importance of having a plan for managing your long-term investments, particularly your retirement accounts. Regular listeners of Smart Money Management know that I have a major concern about how we fund retirement in the United States. In many cases these days, the investment risk is entirely borne by the employee instead of the employer. Often, the employees are ill-equipped to handle investment risk. However, building an effective investment portfolio doesn’t have to be difficult. To get started, you just need to do three things to your account: allocate, diversify and rebalance.
Asset allocation is simply how you spread your investments among the different asset classes. The three main asset classes are cash, bonds and stocks. The correct asset allocation is different for every investor, depending on their individual circumstances. Each asset class has unique properties that are an important part of your overall portfolio. Cash includes things like savings and checking accounts, money market accounts, short-term certificates of deposit and other fixed-income investments with a maturity of six months or less. Cash investments are liquid and characterized by very little, if any, fluctuation in value.
Bonds are fixed-income investments with a maturity of greater than six months. There are many types of bonds - treasuries, municipal and corporate are some of the most common. The value of bonds will fluctuate based on movements in interest rates. Bonds generally provide a steady, predictable cash flow, but not much potential for capital appreciation. We believe cash and bonds provide little protection against inflation.
Stocks represent ownership in a company, and owners of shares of stock benefit from the company’s profit as well as future growth. Stocks offer the potential for capital appreciation, but less predictable cash flows. Stocks are also the most volatile of the three asset classes. (Source: Markowitz, Journal of Finance) Stocks are further classified by size, style and geography. Size is self-explanatory: Large companies, medium-sized companies and small companies. Style refers to value or growth.
Value stocks are generally more mature companies that are attractive because of their valuation relative to their cash flow and other characteristics, and their valuation relative to similar companies. Growth stocks are often newer companies in the early part of their lifecycle, with rapidly increasing sales and market share. Geography refers to where the company is located, either in the U.S. or outside of the U.S.
The correct asset allocation for each investor is different depending on age, goals, financial situation, risk tolerance and time horizon. An investor may have multiple portfolios, each with different asset allocations. For example, let’s say an investor is pursuing three goals: buying a new boat in one year, buying a new house in five years and retiring in 30 years. The account earmarked for the boat will probably be invested almost exclusively in cash, because the use of the proceeds will be in the very short term. The account intended for the new house may contain a mix of bonds and cash, while the retirement account will likely include all three asset classes, with a large portion invested in stocks.
Diversification and asset allocation are related concepts, but they are not the same thing. Diversification can be thought of as not putting all your eggs in one basket. For example, an investor could have a portfolio made up of 20 stocks. That is a diversified stock portfolio, but it may not be the optimal asset allocation because it is made up entirely of stocks. By adding additional asset classes to a portfolio, you could potentially increase returns with the same amount of risk or decrease risk while maintaining returns. (Source: Markowitz, Journal of Finance)
Asset allocation is part of your overall financial plan, and like all aspects of your plan, should be reviewed periodically. The asset classes will have different returns each year, and over time your portfolio can become out of balance. We believe that part of your review process should be to rebalance back to the correct allocation for each asset class. Your overall asset allocation plan will also change over time as you get older, the time horizon for your goals shortens, and your financial circumstances change.
Short-term market conditions may not be a good reason to change your asset allocation plan, however. In fact, adding discipline to your portfolio may be an additional benefit of having an asset allocation plan.
Important Disclosure: Mike Bergen is a Partner, Managing Director at Beacon Pointe Advisors, LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified due to changes in the market or economic conditions and may not necessarily come to pass. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified or attested to the accuracy or authenticity of the information. The discussions, outlook, and viewpoints featured are not intended to be investment advice and do not consider specific investment objectives or risk tolerance you may have. All investments involve risks, including the loss of principal. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss. Bonds are subject to market risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Consult your financial professional for guidance specific to your circumstances.