Asset Allocation

The importance of asset allocation, or the decision about what percentage of a portfolio to devote to various asset classes, cannot be overstated. Investors spend most of their energy and fees picking stocks themselves or paying someone else to do it, but they spend very little time deciding to what sectors, countries, and type of stock or bond to allocate their funds.

It should be just the opposite. Investors should spend most of their time asset allocating and should generally ignore individual stocks. Repeated studies have shown that a large part of a fund or portfolios' performance, for better or worse, can be explained by the asset classes that make it up, not by the individual stocks it contains. Stocks from the same asset classes tend to move in tandem, so all one has to do is pick asset classes, (or allocate), well to outperform.

Trying to sift through information about individual companies is not only quite time consuming (or expensive if you are paying someone else to do it) but also relatively unproductive. Most economists feel this is because of the enormous competition in research. So many experts are analyzing stocks that there are few pieces of public information that can give one an advantage. Asset allocation is much easier than stock picking, and it rewards the diligent investor handsomely.

Our asset allocation tool may be found in the portfolios tab at the top of this page. It presents investors with appropriate ETFs based on their asset allocation strategies.

Happily, ETFs are the perfect tool for the investor focused on asset allocation. They represent just about every asset class available and are cheap, liquid, and reliable. The primary asset classes in which ETFs are available include:

• Large Cap Stocks
• Mid Cap Stocks
• Small Cap Stocks
• Growth Stocks
• Value Stocks
• Sector Stocks
• International Stocks
• Country
• Emerging Market Stocks
• Long-term Bonds
• Mid-term Bonds
• Short-term Bonds
• Real Estate Investment Trusts

Large Cap, or large capitalization stocks for the market value they demonstrate, are the most valuable or largest companies in a market. In the US the Down Jones Industrials or the S&P 500 are the most famous indexes following these. Mid Cap, or middle capitalization stocks, are the next tier of company in terms of size, while Small Cap brings up the rear with the smallest public Small stocks typically outperform over the long-term but are riskier.

Investors are essentially paying for a stream of future earnings, and the growth/value demarcation is a useful one along lines of earnings. Growth stocks represent the half of a market's companies with higher-than-average stock price-to-earnings ratios (or similar valuation ratio). This suggests an expectation that they will grow their earnings faster than average such that in coming years the price paid for earnings will be relatively low.

Value stocks are just the opposite and have lower than average stock price-to-earnings ratios. Normally investors expect these firms to grow more slowly and therefore pay less as a percentage of today's earnings. These investors are also comforted by knowing value companies don't need to improve earnings to meet their expectations. Growth and value can be applied to an entire country's market or a subset.

Sector stocks are groups of companies in the same industry. They are quite useful to play a hunch on a particular part of the economy.

International stocks generally refers to companies of non-domestic, developed economies. Europe, Asia, Australia are examples.

Emerging market stocks are generally quite risky but often sport low price per earnings and substantial potential earnings growth. Brazil and Russia are examples.

Long-term bonds (normally assumed to be of investment grade quality) provide a guaranteed rate of return over 7 years or more but also carry high interest rate risk. Since the bonds lock in a rate for many years, a general rise in interest rates will quickly depress the value of the bonds. And vice-versa, interest rate drops will increase the bonds' value, since investors will flock to them in search of interest rates higher than the open market.

Medium-term bonds generally pay somewhat less than long-term and are less sensitive to interest rate movements. Usually medium-term refers to 3-5 years.

Short-term bonds pay the least but are essentially impervious to interest rates (assuming they are investment grade). Like all bonds, their dividends are considered ordinary income and taxable at relatively high rates.

Real-estate investment trusts are funds that invest in large numbers of commercial properties. They tend not to move in tandem with stocks and thus offer diversification to a portfolio. They may deliver capital appreciation but mostly generate ordinary income dividends.

Many of the differentiators of these asset classes may be used together to obtain finer-grained asset classes. Thus small value stocks are an asset class in their own right, and ETFs are being created every month around these smaller classes.

Only investable, public companies are represented, and private firms are excluded.