I mentioned in my last post my asset allocation plan. I've been aware of the concept of asset allocation for a while, but I didn't really know all the details until I started reading
"All About Asset Allocation". So, I'm going to try to sum it up here.
Nobody can predict the way the stock market will go. Sometimes, you can make a prediction, and have it be correct, or get lucky, but you have the same information and chance that a fund manager does. A fund manager has education on their side, but they're human too, and they won't be right all the time. Overall, funds in the long run follow the market, but they have higher fees. This is an application of the
random walk theory. So, if you want to follow the market and have low fees, index funds are the way to go.
But, there's a prediction problem here too. Which sector or index is going to do well? Every market has good years and bad years. Do you really want to put all of your money into a fund that only invests in 1 kind of stock? A smart investor would invest in more than one market so that his money is diversified. So, the portfolio I created has many different sectors, sizes, and markets that it invests in.
But, not every fund will act the same. Some will go up, some will go down, some will correlate well with others, while some will do their own thing. What if, in a year, my percentages are all different than when I began?
A good asset allocation strategy involves rebalancing. I would sell the excess fund that did well, and use the money to buy from the fund that lost money. The price of the respective funds don't matter, because I'm doing everything as a percentage of my own portfolio.
What does this achieve? There's an old saying: Buy low, sell high. Well, when I'm selling the fund that made extra money, I'm selling those shares for more than I purchased them for. This is the "sell high" half. Then, I take that money, and purchase the fund that costs less then I originally paid. That's the "buy low" half.
There are 2 main theories to rebalancing. One has better performance, but requires extra work and maintenance, and the other requires less work for slightly less effect.
- percentage based: When one of your assets deviates a preset percentage from your ideal, you rebalance. Works slightly better overall, but you have to be constantly keeping track.
- time based: Rebalance after a specific period of time, say, quarterly, or annually.
Which is better? Depends on your style. I'm a fiddler. I love to tweak this, adjust that, change things up a lot. I'm opting to rebalance on percentage, and I'm choosing a relatively low limit: 2%. So, the instant a fund hits 8% or 12%, I'm rebalancing. If I didn't want to think about it until the next year, I would use the other method.
So, in a nutshell, that's asset allocation. I like the concept. I love the fact that it's not depending on somebody else to have better knowledge than me. It's just pure statistics at work.
