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Understanding the Most Important Factor for Successful Investing

By Matt Bell
for Sound Mind Investing

Understanding the Most Important Factor for Successful Investing

We have often described asset allocation as "your most important investing decision." However, it is not a magic bullet that always protects a portfolio from loss, nor does it guarantee market-beating returns. Let's take a closer look at exactly what asset allocation can—and can't—offer investors.

What is asset allocation?

Asset allocation describes the process an investor goes through in dividing his or her money among various types of investments (also called "asset classes"). This typically begins with a decision on how to divide a portfolio between stocks and bonds, but may involve including other broad asset classes, such as gold and real estate, as well. Numerous studies have validated the fact that these asset-allocation decisions determine investment returns much more than the specific investments chosen within each asset class.

Done properly, asset allocation enables an investor to build a portfolio that balances risk and reward, typically based primarily on the investor's age. The younger the investor, the more appropriate it is for the portfolio to be heavily, if not completely, concentrated in stocks and other invest-by-owning kinds of investments. While a portfolio consisting primarily of stocks and stock funds will experience significant ups and downs along the way, such an approach has rewarded the long-term investor better than any other asset class. However, as investors age, they have less time to ride out market swings to the downside. So, it's wise to gradually decrease portfolio volatility by reducing stock-based investments and increasing the bond allocation.

What asset allocation can't do

Perhaps the greatest myth of traditional asset allocation is that it will eliminate losses. Diversifying across different asset classes can decrease the volatility of a portfolio, but there are occasions when almost all asset classes move down together. This was true in 2008; bonds generally made money while everything else plummeted. Still, that year provides a great illustration of how asset allocation impacted how much people lost.

Consider the chart below. An investor who was 100% invested in SMI's stock Upgrading strategy lost -38.8% in 2008. Shifting the allocation mix to 40% stocks and 60% bonds limited losses to -12.7%.

100% Stocks/ 0% Bonds = -38.8%

80% Stocks/20% Bonds = -30.0%

60% Stocks/40% Bonds = -21.3%

40% Stocks/60% Bonds = -12.7%

Of course, this works both ways. As the market has recovered, the 100% stock investor has enjoyed a much larger rebound than those with more conservative allocations.

To fix or to flex?

The process we've been discussing so far is known as strategic asset allocation. This form is what SMI has long taught: begin with your risk tolerance and season of life, and build a more-or-less permanent asset allocation plan based on those factors.

For strategic asset allocation to work, however, it requires investors to stick with the allocation through good markets as well as bad. Normally, the only changes made to the allocations are to rebalance the portfolio annually in order to bring it back into alignment with the initial allocation schedule.

A common problem with strategic asset allocation is that investors' emotions frequently get the best of them. They may start out with the best of intentions to stick with their long-term allocations "through thick and thin," but eventually the fear caused by steep market losses causes them to shift to a more conservative portfolio (that is, they reduce their stock portion and increase their fixed-income holdings). This usually serves to lock in existing stock losses at an inopportune time—when the market eventually rallies, their recovery is slowed by their more conservative allocation.

Understanding tactical asset allocation

There are objective approaches to making allocation changes as well – either changes in how much of one's portfolio is allocated to each asset class or moving completely into and out of asset classes. This is what's known as tactical asset allocation. Such an approach offers a particular set of strengths and weaknesses just as strategic asset allocation does.

Critics sometimes dismiss tactical asset allocation as "market timing," and depending on the way it is carried out, it can be just that. But there are many different approaches to tactical asset allocation, ranging from making small incremental adjustments to an otherwise unchanging asset allocation to making wholesale switches based on various factors.

Arriving at the asset allocation that best fits your personal situation, in whatever form it is practiced, is a vital component of investing success. When it comes to investing, emotional decision-making typically leads to poor performance. A personalized asset allocation model—using an objective, measurable process for dividing your portfolio among diversified asset classes—provides a solid first line of defense against investing-by-emotions.

Matt Bell is the Associate Editor of Sound Mind Investing, the best-selling investment newsletter written from a biblical perspective. SMI wants people to have more so they can provide well for their families and generously support God’s work.

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