Diversification is the foundation of an investment portfolio. While simply being diversified can’t eliminate risk, it can help minimize your overall risk and protect you from catastrophic losses. But what does it mean to be diversified? Everyone tells us about how we need to diversify our investments, own stocks, bonds, real estate, cash, commodities, and everything else. That makes sense, but not many people explain how to go about it. Do you just buy an index fund or ETF that covers each type of asset? What percentage of each should you hold? And when do you rebalance your portfolio, if at all?
One thing is certain, and it’s that there’s no silver bullet allocation that will work for everyone. We all have different investment goals, risk tolerance, and time frames. We also know that just buying a bunch of funds does not always equal instant diversification due to fund overlap. So, before you begin picking a bunch of funds to add to your portfolio in order to become more diversified we first need to understand the basic types of asset allocation: strategic, tactical, and core-satellite.
Strategic Asset Allocation
The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. If you aren’t implementing a specific strategy to your current portfolio, chances are you’re holding a strategic asset allocation and don’t even realize it. With this type of allocation the investor simply picks and chooses different funds and asset classes that will hopefully minimize risk with offsetting investments that generate a return within a specific range.
This is the most common type of allocation where investors typically pick a few stock funds and then offset it with a certain percentage of bond funds that’s suitable for their age or risk tolerance. The idea is that you can strategically offset some of the risk from stocks by adding some safer investments such as bonds or cash equivalents. With that mix and the known expected historical returns of each type of asset you have a defined range in which you deem your portfolio successful.
Strategic asset allocation is also the allocation that can benefit from regular rebalancing. Since you are primarily concerned with keeping your overall stock/bond mix in-check and therefore keeping your risk at a suitable level you’ll want to rebalance at least once a year as those ratios begin to skew from your target. Over time, either stocks or bonds will outperform the other and make you overweight in one area and underweight in another. By rebalancing back to your target you’re effectively taking some of your profit by selling high and reinvesting it in the asset that is lagging, therefore buying low.
Tactical Asset Allocation
Think you have what it takes to beat the market? If so, tactical asset allocation is for you. With this method an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains. Tactical investors aren’t concerned about owning the whole market or just sitting on a few index funds for years at a time. Instead, they try to ride the tide and buy into asset classes that are on the move. If you’re someone who jumps out of stocks when things head south and move into bonds, or dump your money into gold because that’s the current hot commodity, you’re a tactical investor.
But tactical asset allocation doesn’t simply have to do with trying to find the current hot sector. You can also be a contrarian investor. A contrarian usually goes against the grain and instead of buying into the current hot investment they buy into something that’s been beaten down in hopes that it is undervalued because nobody is paying attention to it. This will hopefully result in investors coming back to that asset and driving the price up so the contrarian and eventually sell for a significant gain.
Keep in mind that this type of asset allocation is riskier than others because it does take an active approach. Anyone can get on a hot streak or get lucky, but don’t forget that even the best money managers in the world can’t consistently outperform the market forever. This strategy is usually not well-suited for your long-term assets such as those used for retirement, but if you have an investment account on the side or simply limit this type of strategy to a small portion of your overall portfolio you can still try to take advantage of moves in the market without putting everything on the line.
Core-Satellite Asset Allocation
Finally, we come to the core-satellite asset allocation strategy. This strategy is more or less a hybrid of both the strategic and tactical allocations mentioned above. Here, your portfolio is essentially made up of two components:
- First, a core holding of stocks, bonds, or index funds make up the bulk of your portfolio. This is the strategic component that uses the offsetting risk strategies mentioned above. The core of your portfolio may consist of anywhere from 50-80% of your total portfolio.
- The remaining portion of your portfolio is your satellite allocation which may implement more of a tactical approach. While your core holdings make up the bulk of your portfolio and won’t change much over time, your tactical component allows you to still scope out opportunities in the market. This is where you would take a more active approach and try to take advantage trends without risking your entire portfolio.
This strategy is great for those who want to be more involved with their investments without relying entirely on their investment selection success. With the bulk of your holdings following a more passive approach you will still generally follow the market with relative ease, but you also have the potential to enhance your gains (and possibly losses) by managing some of the money on your own.
Which Strategy is Right For You?
There’s no right or wrong answer because it really depends on what you’re comfortable with and how active a role you want to play in your portfolio. That being said, most people will probably benefit the most from taking a traditional strategic approach that consists of creating a tried and true mix of stocks and bonds suitable for their age and risk tolerance, but the recession and stock market performance has a lot of investors thinking twice about this strategy. Some have abandoned the strategic model completely and are now pure tactical investors, but I’d caution anyone about making that drastic of a move. At least with your entire nest egg.
Personally, I use the core-satellite approach. About 80% of my total portfolio consists of long-term and low-cost funds that give me about a 75% stock and 25% bond position. Then, I do have about 20% of my assets that I have more control over and use these funds to buy ETFs, funds, or individual stocks that I think will provide above average returns in a year or two. It has proven to be a decent strategy for the past four or five years. As a whole I typically perform on par with, or slightly outperform the market from year to year. In fact, 2009 was a great year for this strategy as I picked up a number of individual stocks at near record low prices such as GE, Abbott Labrotories, and Intel only to see them surge in price, boosting my returns on the year.
So, what kind of asset allocation approach do you use? If you are thinking about adding some tactical investing to your portfolio it’s important to keep trading costs down as frequent trading and commissions can have a negative impact on your total return. So, stick with a low-cost or free broker such as TradeKing.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.