Previously we touched upon the effects of fees and taxes on portfolio performance. We are now on to the third principle of asset allocation. If you remember, our principles are about focusing on what we can control. So why is controlling asset allocation so important?
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1996. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. *Morningstar
Asset allocation is the combining of different asset classes in an attempt to control the risk and return parameters of a portfolio. Basically, this means that the ratio of stocks to bonds you have will determine your risk and thus your chance for higher returns. As you can see in the simple example above, the allocation of stocks vs. bonds significantly contributed to the investment experience you would have had over the illustrated 20-year period.
If you were in a portfolio of 100% bonds, you would’ve made a descent 4.9% return over the 20-year period without too much volatility. But if you were invested 100% stocks, you would have had a very bumpy ride; however, taking that bumpy ride would’ve given you an 8.2% return. The three allocations in between (75/25, 50/50 and 25/75) all had risk and return figures that lined up with more risk equaling more potential return.
The key to constructing your portfolio is knowing the essential balance of how much risk you need to take to get the potential returns you are looking for and balance that with the amount of risk you can handle taking.