Asset allocation sounds painful. And unfortunately, this much-discussed investment technique can be a trying idea.
Not only is it confusing -- ask 10 analysts what the right mix of stocks, bonds and cash is, and you'll get 20 answers -- it's tough to calculate. But that doesn't mean it's not worth attempting.
Asset allocation is "one of the most important financial decisions you will make," said Bill Lippman of Franklin Funds in San Mateo, Calif.
But most investors don't know or track the mix of various asset categories in their portfolio. That often leaves savers ill-prepared to match their investments to their financial demands, experts say.
So get out your pencil, calculator or personal computer. It's time to figure out your asset allocation.
(1) What to count: Not every penny should be included in an asset-mix calculation, limiting your work to "investables," as Mr. Lippman put it.
Money in checking accounts, savings for short-term needs and emergency funds, for instance, should not be included. As a rule, money that can be put away for more than three years -- the minimum time experts say cash should be committed to a stock -- is ripe for your asset-mix study.
Savers may include assets that they control only indirectly, such as retirement-savings plans at work. This can give investors a better view of how to handle risk-taking with this money.
Rather than using asset-mix studies on their entire portfolio, many investors tend to key on individual portions of their savings, says Michael Hines of Fidelity Investments in Boston. This enables them to match risk-taking with specific needs, whether it be financing a college education or retirement, Mr. Hines said.
"Many say it's much more manageable that way," Mr. Hines said.
(2) How it's done:
First, gather up recent statements from your financial institutions and savings programs. Try to get information quoted from the same date.
Next, jot down investments by name, dollar amount and asset mix. Some mixes are simple. For example, common shares of General Motors are 100 percent stock. Treasury securities longer than one year in maturity are 100 percent bonds. Investments in money-market funds are 100 percent cash.
This can be tricky for some mutual funds, particularly "balanced" funds that might invest in many types of assets. Contact your fund company to get the asset mix.
Then, determine how many dollars from each investment fall into the stock, bond or cash category. Add up numbers for each category and divide tallies by the total amount in your portfolio.
(3) Tricky spots: Certain investments pose odd questions for this calculation.
Many mutual funds have changing asset mixes -- with some funds varying wildly. Experts say that most investors should learn the objective of the fund or its typical asset mix.
For example, a stock fund with 4 percent cash usually should be treated as an all-stock investment. Even something such as the Fontaine Fund, a defensive stock fund now 70 percent in bonds, should be tabulated as 100 percent stock because its goal is to beat the Standard & Poor's 500 stock index, Richard Fontaine, the manager, says.
For funds that change assets, such as "balanced" or asset-allocation offerings, an investor should consider using the average or "neutral" mix, ignoring switches fund managers take to maximize returns.
Utility and real estate investment trust (REIT) shares also are oddities because these shares pay high dividends but are sensitive to interest-rate swings and economic developments like bonds. Investors should consider whether they're holding these issues mainly for income (100 percent bonds), capital appreciation (100 percent stocks) or both (somewhere in between).
"Junk bonds," whose high dividends come with heavy risks, are actually much more like stocks than bonds, experts say. Thus, savers holding them could treat them as stocks in their asset-mix calculation.
(4) Benchmarks: Now that the magic mix number is tabulated, you probably want to know what is the best asset mix. That's the hard part.
The aim of asset allocation is to balance risk, reward and time. Historically, stocks have earned investors more money (10 percent a year) than bonds (8 percent) or cash investments (6 percent). The longer one's investment time frame, the more likely that history will repeat itself in your portfolio.
"Let time work for you," said Albert Margeson of TNE Fund Group in Boston. "You don't need diversification [among asset categories] if you have all the time in the world."
Because many savers' investment horizons are short, and they can't stomach portfolios exclusively invested in stocks, the science of asset allocation has evolved.
Virtually every brokerage, investment company and financial adviser can suggest an asset mix that can fit your needs. Rather than targeting current market conditions, they often take a longer-term view and juggle potential gains against needs for income or investor skittishness.