One can become completely overwhelmed by the different elements and complexities
of investing. Merely glancing at the stock page of the Wall Street Journal can
send people into a tizzy. Fortunately, to clear the fog for both the beginning
and advanced investor, there is help - a concise and easy rule to follow for
building all investment portfolios. The remedy is known as asset allocation.
As a strategy with which to approach investments, asset allocation will allow the
investor to limit risk while increasing returns. The practice of asset
allocation is simple: develop a diversified portfolio of investments. The
concept of developing a diverse portfolio and benefiting from asset allocation
can best be seen through the analogy of a pyramid. The pyramid is divided into
four levels, each level representing a different tier of investment. Together,
the pyramid creates a diversified and healthy portfolio. The bottom level of the
pyramid, the foundation upon which the entire pyramid rests, is capital
preservation. These investments have the sole purpose of preserving capital
with minimal risk and consequently small returns. The second level of the
pyramid, the income level, is developed to maximize current income while
assuming the lowest possible risk. This level, with minimally increased risk,
opens many new doors of investments. The next level of investments is concerned
with growth. This level of the pyramid focuses more on increasing net worth
than on realizing current income. The investments on the growth tier assume
slightly more risk than the previous levels and have the opportunity to acquire
greater returns. The final category of the pyramid, the level which occupies
the smallest area of the portfolio, is aggressive growth. Aggressive growth,
also known as speculation, assumes the most risk with the expectations of
realizing substantial gains. Asset allocation has successfully increased returns
while limiting risk due to the principle of diversification. As the four tiers
are concerned with different investments, the levels are able to check and
balance each other.
Jonathan Clements asserts in the Wall Street Journal that
"when some of [the investments] are struggling, others may take up the slack.
As a result, a well-diversified portfolio should do reasonably well most of the
time, which can be a great comfort to antsy investors" (WSJ C1 Aug. 8, 1995).
The Dean Witter publication, Newsworthy, highlighted the results of portfolios
which utilized asset allocation. The Dean Witter portfolio of diverse
investments grew 19.9% over a 12 month period. This can be compared to the
average annual growth of the stock market which is around 10.2%. This study,
which illustrated a portfolio growing double what the stock market grew,
strongly supports the use of asset allocation. The moral of the article can
simply be found in the cliche, don't put all of your eggs in one basket.
