Few subjects in investing are more misunderstood than asset allocation. Brokers don’t like to talk about it. Instead, they entice their clients with stocks they believe will “take off” or fund managers they think are “hot.”

Asset allocation refers to the division of your portfolio between various asset classes, like stocks and bonds.

Maybe asset allocation is the stepchild of the investing world because it offers no promises of outsized returns. It doesn’t make for scintillating cocktail conversation. Have you ever heard someone bragging about their terrific asset allocation?

The lowly status of asset allocation is ironic. It’s critically important. More than 90 percent of the variability of a portfolio’s performance over time is due to asset allocation. This means that more than 90 percent of the movement of your portfolio from quarter to quarter is due to the market movement of the asset classes in which your portfolio is invested.

Asset allocation is far more important than stock picking or mutual fund selection, yet those subjects typically dominate the discussion between brokers and their clients. Has your broker ever called and asked to discuss your asset allocation?

Asset Allocation Guidelines

Now that you understand its importance, here are some guidelines for determining the right asset allocation for your investment objectives and tolerance for risk.

1. Take a short asset allocation questionnaire.

2. If you have less than five years before you will need 20 percent or more of your invested assets, you should have no exposure to stock market risk. As in zero.

3. If you have a seven-year time horizon, you can have up to 50 percent of your portfolio in stocks.

4. If you have a fifteen-year time horizon, you can have up to 100 percent in stocks.

5. If you fit above or below these time horizons, you will need to adjust your portfolio accordingly.

Asset allocation doesn’t remain stagnant. Life events (like health changes, divorce, and inheritance) can require a change in your asset allocation. It’s a good rule to revisit your asset allocation every year and change it if required.

Once you determine your asset allocation, you have made your most critical investment decision. However, you’re not done. You need to resist the entreaties of brokers and advisers who tell you they can beat the market by investing in actively managed mutual funds (where the fund manager attempts to beat a designated benchmark).

William F. Sharpe, a Nobel Prize–winning economist, wrote a classic paper entitled “The Arithmetic of Active Management.” It should be required reading for every investor. Here’s his conclusion: “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.”

The Smart Investing strategy for investors is clear: Once you have determined your asset allocation, limit your investments to a globally diversified portfolio of low-cost stock and bond index funds.

Congratulations! You have now maximized your returns and minimized your risk. Best of all, you didn’t fall victim to the false promises of a “market beating” broker or adviser.

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. . His latest book is Timeless Investment Advice.

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