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The Importance of a Balanced Investment Diet

By Dr. Steve Sjuggerud
Tuesday, December 26, 2006

Steve Sjuggerud’s note: The DailyWealth staff is taking off the holiday week to spend time with friends and family. In place of your regular daily issues, you’ll find a series of essays written with the goal of making you a much better investor in 2007. We hope you enjoy. Happy Holidays.

 

Today’s message is simple. But it is the most important lesson in investing...

HOW you divide up your assets among the three classes is infinitely more important than WHICH stocks you choose.

Think of asset allocation (how you divide your investment dollars into stocks, bonds, etc.) as you would your diet. A diet of all meat would literally kill you. But a diet of all vegetables, while it may not kill you, will likely lead you to inferior overall performance. We all know this. And we know that some balance of these is optimal – hence the phrase “well-balanced” diet.

The same holds for investing. Investors with “all-stock diets” can suffer big losses in a bear market. Bond investors (like broccoli eaters) haven’t been killed – except by boredom – as bond yields have fluctuated between approximately four and five percent for a few years now.

We know that some mix of stocks and bonds over the long run must be the “optimal” mix, to give us healthy gains and (at the same time) ward off portfolio heart attacks. Let’s go over the details...

Asset Allocation Accounts for 90% of Portfolio Porformance

Now-famous studies (by Gary Brinson in 1986 and 1991) show that over 90% of portfolio performance and variability can be explained by asset allocation – your mix of stocks, bonds, and cash.

The other 10% is made up of factors including market timing and stock selection. This makes sense. If your asset allocation is 100% stocks, and the market falls 20%, chances are, you’ll be down pretty close to 20%, regardless of the stocks you choose. And if your allocation is 100% bonds, and bonds earn 6%, chances are, your bond portfolio would have made you 6%.

Clearly, by far, the most important decision you make is how you divide up your pie of assets. If those studies about portfolio performance are even remotely correct (they do intuitively make sense), it means that spending your time picking stocks isn’t the best use of your time – because a rising tide raises all ships. (And, yes, unfortunately, an outgoing tide has the opposite effect.)

How to Figure Your Own Personal Asset Allocation:

The more you read about this topic of asset allocation, the more confusing it often gets. Different “scientific” studies on this topic give strikingly different results. (In fact, many studies based on only the last 10 years of data said you should be 100% in stocks... but you would have been clobbered in recent years on that advice.) So, while we recommend doing all the homework on this topic, never forget the basics:

1) The 100 Minus Your Age Rule is a great starting point for how much you should have in stocks.

2) For example, if you're 30 years old, you should have 70% of your investable funds in stocks. And if you're 70, you should have 30% in stocks. At the age of 70, you should be focused on steady income rather than a big stock gain.

3) The 60% stocks/40% bonds mix is a good mix of risk and return for many “set it and forget it” portfolios.

4) For best results, you’ve got to diversify among different types of stocks and bonds as well as among asset classes. For instance, I think allocating a portion of your portfolio towards collectibles is a great way to diversify right now.

It bears repeating, the truth is that there is no one “Perfect Portfolio.” It’s different for everyone based on age and risk tolerance. However, if you stick with these four basic suggestions, you should be more than capable of finding the right one for you...

Good investing,

Steve






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