Asset Allocation — JOHN DIFINI

Asset allocation is a risk management technique that strives to balance risk versus reward by dividing portfolio funds amongst the various asset classes. Asset allocation typically applies to the main asset classes, stocks, bonds, and cash equivalents.

An investor’s risk tolerance, goals and investment time horizon are factors that influence asset allocation. The following flowchart shows a straightforward way to determine asset allocation for a retirement portfolio. For example, an aggressive 35-year-old could allocate his retirement portfolio as follows:

%Equities = 85% of portfolio (risk_factor - age = 120 - 35)
%Bonds = 15% of portfolio (100 - %Equities = 100 - 85)
International Equities = 35% of equities

Asset Allocation for Retirement Portfolio

For general living expenses and emergency funds, the asset allocation looks completely different than that of a retirement portfolio. For such short-term savings, the following flowchart depicts a way to choose an asset allocation. First, for money that will require withdrawals of less than $250, use a standard checking account. For larger sums of money, use money market and bond funds, but to select the right investments, you'll need to know your state and federal tax rates, first.

To find the state tax rate for your state, Google "State Income Tax Tables". To find your federal tax bracket, you need to know your Adjusted Gross Income (AGI), which you can find on your prior year’s tax return (e.g. line 11 on Form 1040). You can also estimate your AGI by subtracting retirement contributions from your total income. Finally, to find the tax rate associated with your AGI, Google "federal income tax rate schedules".

Now, it gets a bit complicated with all the "if that, then this" stuff. If your state rate is less than 5% & your federal rate is less than 33%, choose funds that pay taxable dividends. If your state rate is greater than or equal to 5% & your federal rate is less than 33%, choose Treasury funds. If your state rate is less than 5% & your federal rate is greater than or equal to 33%, choose federal tax-free funds, for which the dividends are still taxed at the state-level. Lastly, if your state rate is greater than or equal to 5% & your federal rate is greater than or equal to 33%, choose state-focused tax-free funds.

Regardless of your tax situation, you'll want to choose funds with low expense ratios. For money market funds, a 0.15% expense ratio is excellent. For bond funds, a 0.20% expense ratio is also excellent. Where do you find such low-cost funds? Vanguard is the industry leader, but USAA and Fidelity offer great options too.

Asset Allocation for Living Expenses & Emergency Funds

Note that the term asset allocation implies Diversification, meaning that an investor wouldn’t want to choose just one asset class like stocks. The term also generally applies to broad asset classes versus asset categories. As stated above, examples of asset classes are stocks, bonds, and cash, whereas examples of asset categories are large-cap, mid-cap, and small-cap. Types of asset allocation include Tactical and Strategic Asset Allocations as described below:

STRATEGIC ASSET ALLOCATION

Believes in: Efficient Market
Active/Passive: Passive Investing
Buy-n-Hold/Market Timing: Buy-n-Hold – but not necessarily true if one is rebalancing frequently
Asset Class % Range: Rigid targets
Rebalance Technique: Periodically sell winners & buy losers