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How Advisers Can Help Investors Understand Asset Allocation

Asset allocation and its role in portfolio diversification are key points for clients to understand

Asset allocation is a common term among financial advisers and those involved with providing financial advice and investing. While it might be a common term for those in the business, do most investors truly understand it and its value?

This is an area where financial advisers can provide expertise and guidance to their clients.

While advisers likely won’t want to go into excruciating details about this topic, it’s important to help clients understand why you invest their money in the way that you do.

Don’t put all Your Eggs in one Basket

This phrase is still the best explanation of asset allocation that I’ve seen over time. It’s also one that most clients will understand. Virtually all clients will understand the need to diversify their investment portfolio at least among stocks, bonds and cash. I think most will also understand the level of downside risk inherent in each of these asset classes.

Beyond the basic stocks, bonds and cash there are other asset classes available. These include real estate, gold and precious metals and other alternative assets. Even within stocks and bonds there are several sub-asset classes. In stocks there are large-, mid- and small-cap stocks, as well as growth value and blend. There are foreign stocks, including those from emerging markets.

Within bonds there are short, intermediate and long-term. There are corporates, investment grade, Treasuries, minis and high yield, to mention a few.

In explaining this to clients, it's not as important to go into every asset class but rather the concept that you are trying to come up with the best allocation that is tailored to their time horizon, their risk tolerance and one that offers the potential returns they need to achieve their goals.

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The Investment Policy Statement

Many financial advisers put together an investment policy statement (IPS) for their clients. This is like a business plan for the client’s portfolio. The IPS will outline the types of investments that can be considered. These could include individual stocks and bonds, ETFs, mutual funds and cash investments.

The IPS will also spell out a target asset allocation for the client including target percentages for each asset class. The IPS will also spell out the trigger point for rebalancing back to the target allocations. Deviation of the allocation by +/- 5% is a common rebalancing trigger.

Non-Correlated Assets

With clients for whom you think this conversation makes sense, discuss the concept of non-correlated assets, or at least those with a low correlation to each other.

Bonds and large-cap stocks are an example. Most correlation charts depict these asset classes with a low, and in some cases negative, correlation with each other. Depending upon your client’s comfort level with these types of topics you might show them a correlation chart from a source you like to use, or perhaps show them the performance of the holdings you are suggesting over various types of market conditions.

Asset Allocation Changes Over Time

It's important to emphasize to clients that asset allocation is a risk moderation tool that will evolve over time. A number of factors will influence the asset allocation that you recommend for them including:

Their age: Generally, as your clients get older it’s likely that you will lighten up a bit on their allocation to riskier asset classes.

Changes in markets and related factors: Like anything else, a client’s asset allocation is not static. On the other hand it does provide a basis of stability in that it is a reference point to rebalance back to during periods of stock market turbulence.

Asset allocation and its role in portfolio diversification are key points for your clients to understand. Be sure to explain it to them in easy to digest terms so they understand this key concept.