There’s been a considerable amount of discussion here as well as in the personal finance blogosphere on the subject of asset allocation (I particularly like this bit on it by my blogging buddy Mrs. Micah). Asset allocation is, in a nutshell, is how much of your total portfolio (your allocation) you put into, for example, domestic stocks, bonds, or international stocks (various assets). When I discussed the end of year performance of my portfolio, I noted that my goal was to have an asset allocation of 50% domestic stocks, 25% international stocks, and 25% bonds; to explain my model relatively quickly, I took 115 and subtracted my age at the time (40), and came up with the number 75. 75 then became my asset allocation for stocks, 2/3 of which would be in domestic stocks (50% of my total portfolio) and the remaining 1/3 in international stocks (25% of the total). What was left–25%–was to go into domestic bonds.

Looking at the allocation of my portfolio right now, we see this:

Domestic Stocks: 44.54%
International Stocks: 18.94%
Domestic Bonds: 36.52%

What does this tell me? It says that the performance of stocks has not been great this year to date; it also tells me that when it’s time to consider rebalancing my portfolio (which I do once a year), I actually want to put more money into stocks. That’s correct: it’s not telling me to run for the hills from my stock market investments, it’s actually telling me to increase the amount of stocks I’m buying relative to the bonds I’m buying. Why? Because the market is down and I can get more for my money in the stock market (I will look at rebalancing a little later in the year).

This is a large part of the purpose of asset allocation; not only does the bond portion help to prevent the portfolio from having even larger losses when the stock market nosedives, the total allocation gives me an indicator of where to put future investments (and possibly even to move money between the various assets). Asset allocation gives you an idea of where to put your money next. Even when I stick to my 115-age formula, we’re only talking a difference of 1% a year; this year I’d say 74% in stocks and 26% in bonds–not very different than last year.

I’m hoping this example shows the importance of asset allocation to those of you beginning with portfolios!

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