Investing Principle 5: Get the Mix Right

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
July 22, 2008

The sixth article in an 11-part series on Schwab's investing principles.

On the surface, asset allocation is a simple concept: it's the process of spreading out one’s portfolio across various asset classes. (By asset classes we mean different types of investments, such as stocks, bonds and cash.) However, upon further inspection, you may begin to feel overwhelmed by the many facets of asset allocation. To help you make sense of it all, we'll look at three important aspects of asset allocation and what they mean to your portfolio.

Spread your money out
Your asset allocation is responsible for a substantial portion of your portfolio’s performance. To illustrate, let’s imagine we have a pair of investors: Barry Brazen and Melvin Moderation.

Barry puts all of his money in U.S. stocks. He’s well diversified in his stock portfolio, but nevertheless, it’s all stocks. Like Barry, Melvin also invests in U.S. stocks. However, Melvin's approach to asset allocation varies from Barry's because he spreads his bets out a bit. Melvin owns not only the stocks of U.S. companies, but also a bit of cash, some bonds and a dash of non-U.S. stocks, as well.

When U.S. stocks are performing well, it should come as no surprise that Barry’s portfolio thrives when compared with Melvin’s. The late 1990s are a great example of this. However, when the U.S. stock market struggles, it will be very difficult for Barry's portfolio to outperform Melvin's because Melvin has diversified across asset classes that behave differently. And, as history suggests, Melvin's diversified portfolio will help him ride out turbulent times like, say, the infamous tech bubble of 2000-2002.

3 important steps	10 proven principles
Create a plan	1. Having an investment plan that is realistic and actionable is crucial to meeting goals. 2. Understand your plan, follow it and adjust it when things change in your life.
Put it into action	3. Saving and spending rates have the greatest impact on success. 4. Diversification is the second-most important factor in reaching goals. 5. Select the asset allocation that’s right for you and stick with it. 6. Choosing professionally managed investments can be a better way to invest. 7. Acting now generally beats waiting.
Stay on track	8. Periodic checkups keep a portfolio healthy. 9. Progress toward goals is more important than short-term performance. 10. Use the right benchmarks to evaluate performance.

Make a conscious decision
Your approach to asset allocation should be a conscious decision and not just something you stumble upon. Institutional investors set a great example. Every few years they carefully address the following questions:

Am I comfortable with my current level of risk?
Which obligations have I committed to funding in the future?
What are my expectations for the long-term future return, risk, and correlation between different asset classes?

They will then select an asset allocation that best matches their situation.

Individuals should go about selecting their asset allocation in a similar fashion. Discard the notion that there is one perfect asset allocation plan. There are a number of asset allocations to choose from, some of which work better for conservative investors and some that may work better for those who want to be more aggressive with their portfolio. What you need to do is find the one that’s right for you.

Stick to your plan
Most importantly, stick with your asset allocation and resist the temptation to fiddle with it, even during times of market volatility. Assuming you followed a thoughtful process when you first created your plan, it’s our view that you should change your asset allocation only when you’ve had a substantial change in your circumstances.

Of course, this is easier said than done. Investors often feel conflicted when deciding between aggressive and conservative allocations, as aggressive allocations tend to have higher rates of return. However, higher returns go hand in hand with higher risk and, when these stock-heavy, aggressive portfolios hit rough patches (as they always do), there’s a tendency to bail out and move to more conservative investments like cash.

We call this market timing and, if you’re able to call market tops and bottoms with unerring accuracy, there’s no question that it’s a great strategy for you. Unfortunately, there are two problems with this practice.

First of all, you need to get two decisions right: You need to know when to get out of the risky asset classes, but also when to get back in (because stock markets tend to recover). If you get out but get fail to get back in at the proper time, you’ve not accomplished much of anything. In fact, you may even hurt yourself if you sell after the downturn starts and aren’t around during the recovery.

Second, we just don’t see persuasive empirical evidence that suggests individuals—or professionals, for that matter—are able to effectively time the market under real-world conditions.

We suggest you take a first step toward making sure your portfolio's asset allocation is where it needs to be. If you’re a Schwab client, Schwab.com offers a number of ways to do this.

If you already have an asset allocation plan but aren’t sure whether your portfolio is consistent with it right now, review your Quarterly Portfolio Profile.
If you don’t have an asset allocation plan, a good place to start is by using the Portfolio Checkup tool.
If you’re more comfortable discussing your plan in person, there's always someone you can talk to at Schwab. Call and schedule a Complimentary Consultation today.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The types of investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Examples provided are for informational purposes only and not intended to be reflective of results you should expect to attain.

Diversification strategies do not assure a profit and do not protect against losses in declining markets. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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Schwab's Investing Principles

Intro: Becoming a Successful Investor

1. A Blueprint for Success

2. Stick With Your Plan

3. The Top Success Factor

4. Diversification Is Key

5. Get the Mix Right

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