Equity Asset Allocation

Before proceeding with determining your equity asset allocation, be sure you have read my previous posts: Are you ready to begin investing? and Investing for the Short and Long Term, where you can determine what type of investing you are ready for and where you should place your money for the short and long term.

Determining your asset allocation is the most important step in investing. This is a long term approach to investing and has been proven to be more important in your success than trying to time the market. A great book on the subject is Asset Allocation: Balancing Financial Risk by Roger C. Gibson. In this post I am just going to concentrate on the equity portion of your investment, but much of this applies to your entire portfolio. I will give a few guidelines for now and next post discuss my current asset allocation.

First there a few assumptions you must agree to before beginning.

• This is a long term strategy
• The sectors your are investing in will go up in the long term

Now to the guidelines:

1. Use a diversified approach. Anyone who has been following the markets the last 3 years can see the value of diversification. We have seen multiple sectors lead the market and then pull back, whether it's been housing, large caps, gold, oil, emerging markets, etc. Your goal is to have exposure in all these areas. Focusing on just one would work if you could always predict which will be the winner this year, but that is nearly impossible. You can certainly overweight your allocation to favor one, but should have exposure in all. To stay truly diversified you need to invest in sectors that are uncorrolated, so that they don't all go up and, more importantly, down at the same time. Everything has some corrolation to one another, but there are different degrees, for instance oil is negatively correlated to large CAP stocks, gold is positively correlated to inflation, small CAP stocks are strongly correlated to larg CAP.
2. Stay comfortable. You need to be comfortable with the risk level and volatility of your allocation. Just as you have already allocated between equities and bonds to meet your comfort levels with risk and volatility. More volatile areas of the market such as commodities or emerging markets, may not be something you can stomach, even if they are promising higher returns. And this is important because of...
3. Stick to your allocation. You need to choose an allocation and stick with it. Otherwise you are starting to play the market timing game. Tweaking your target allocation every year after analyzing where things are going makes sense, but do not try to tweak every month.
4. Don't chase past performance. You need to be forward looking in your allocation. Often areas that have been the biggest losers last year, might be good choices for this year. Likewise, winners at all time highs maybe ready to fall (think real estate, tech bubble)
5. Low expenses. Choose your allocation first and then find funds with the lowest expense ratios. I believe in sticking with index based funds or ETFs, especially in taxable accounts. This is because they have shown to outperform actively managed funds in the long term, have low expense ratios, and very low distributions since they have a low turnover.
6. Re-balance your portfolio yearly. After you choose an asset allocation you believe in and are comfortable with, rebalance it at least yearly, or whenever the allocation deviates by 3 or more percent. This ensures that you capture any gains made and transfer them to your lagging sectors. This is a good idea for 401ks and IRAs, however this will trigger capital gains tax in taxable accounts, so an alternative is to rebalance by adding new investments such that you rebalance it.

This brings me to the investing discussion. You can buy shares via lump sum or regular installments throughout the year. A few methods exist:

1. Dollar Cost Averaging. Where the same amount is invested each time period for each fund according to your allocation. This keeps your investment amount constant, but your purchase amount changes, as you buy more shares when they are cheaper and less when they are expensive.
2. Value Cost Averaging. You change your investment amount depending on the current value of your investments. You set a target value of growth for each fund each period and only invest enough to bring it up to that target.
3. My method. My method is a combination of both, I try to constantly maintain my target allocation. So I am in effect rebalancing each period by adding new money.

In my next post I will discuss what my current asset allocation is and invite others to post comments as to what they are using.