Ira Rapaport

Asset Allocation Serves Its Purpose
by Ira Rapaport

IF THERE EVER WAS a stock market period that demonstrated the importance of diversification, this was it! Asset allocation-not investment selection or market timing-is one of the most important factors in determining the success of your portfolio. A lasting lesson from this market debacle is that diversification is one of the most significant aspects of successful investing.

Simply stated, asset allocation is the way to select your investments based on your objectives, time horizon and tolerance for risk. The term "asset classes" refers to the broad categories of investments available. The three primary asset classes include: cash equivalents, bonds and stocks, and there are numerous subsets for each of these categories.

Cash investments provide stability as well as liquidity for financial emergencies, while bonds offer steady income and can help cushion the swings in stock prices. Stocks, however, have historically provided the highest long-term returns and the best long-term protection against inflation.

Many professional advisors and institutions recommend asset allocations that include large-cap stocks, small-cap stocks, international securities, bonds, cash equivalents and sometimes real estate. In aggregate, these asset classes help diversify a portfolio providing a historically lower portfolio risk exposure over the long run.

Equity classes are delineated by market capitalization, which is the measure of a company's worth. To find a company's market capitalization, multiply the number of shares outstanding (that are publicly available) by the stock's current market price.

Generally, large-caps are stocks with a market capitalization greater than $10 billion. These are the largest, most well established companies. Small-caps are stocks with a market capitalization generally less than $1 billion. These are smaller, sometimes newer companies that are still developing. In between $1 billion and $10 billion of market capitalization are mid-caps.

Large-caps and small-caps have historically taken turns outperforming one another in broad multiyear cycles. Diversifying across growth and value stocks of various market capitalizations also reduces portfolio volatility over time.

Lipper, Inc. reported that the average U.S. stock fund fell 13.1% in the three months through March of 2001. Fewer than 8% of the stock funds avoided red ink in the period. The sole bright spot were funds specializing in small-cap value stocks, which returned 1.1% on average.

The positive return of small-cap value funds is an important reminder of the benefit of spreading one's money among different types of stocks. A year ago, small-cap value funds, which look for low-priced bargains among companies with relatively small market capitalization, were considered "pariahs;" meanwhile, various types of growth funds, all heavy in technology stocks, were market darlings.

Now, the standings are reversed, as small-cap value funds gained 15.7% over the past 12 months and mid-cap growth funds have tumbled 40.2% over the past 12 months.

There are two main asset allocation approaches to consider - strategic or tactical. Strategic asset allocators generally allocate a fixed percentage of assets among several asset classes and make no attempt to forecast performance. The primary investment objective is to provide solid rates of return at moderate risk levels through diversification of several asset classes. Secondary goals include minimal turnover and modest transaction costs.

Tactical asset allocation attempts to do more by introducing an element of market timing into the equation. Tactical asset allocators seek to increase returns by forecasting the performance of various assets allocated within each asset class. The performance record of the tactical asset allocation strategy has been somewhat mixed due to the sheer difficulty of identifying which asset classes will outperform others.

Investors should develop a long-term asset allocation strategy that they are comfortable with and stay the course. There will always be some good news and some bad news. If you understand that the market will continue to fluctuate and build your plan on that premise, you will not abandon your long-term strategy at every media-reported blip or bump.

Investors should adjust their strategy and revisit their asset allocation as life goals change. Nervous investors are not quite charging for the exits, but many of them have been heading for the sidelines, waiting for the volatile stock market to hit the bottom. This is evidenced by the Investment Company Institute's report indicating that money market funds currently account for 29% of all mutual fund assets, a six-year high.

Long-term performance of major asset classes reveals that diversification has historically delivered significant returns. Furthermore, broadly diversified portfolios can lower risk without diminishing the potential long-term return. Of course, past performance is no guarantee of future results.

Ira Rapaport is an advisor with RINET, a division of Boston Private Financial Holdings.