Matching Your Risk Return Profile to Achieve the Optimal Asset Allocation
By Bill Griffith, Jr., CFP®
How to identify the portfolio with the lowest risk and highest return is always a challenge when you invest. A one-asset class portfolio may achieve a higher return over a certain period of time than a multi-asset class portfolio but the object of diversification is to identify the portfolio that provides the highest return over the long run for a given level of risk.
When you invest for retirement or create an investment portfolio designed to help you achieve other financial goals, the process begins with a thorough exploration of your goals and dreams, progressing through the identification of your risk tolerance and desired return, and culminating with an extensive review of your resources.
Effectively matching your risk/return profile to your target portfolio will provide the optimal portfolio for your particular situation, based on your objectives. An investment policy and asset allocation strategy can be designed only after the appropriate risk and return measures are derived and optimized to achieve your goals. Once this process is complete and a target return is established, you can buy stock, bonds, real estate and other assets to implement your asset allocation strategy. Stocks are typically divided between domestic and foreign and large and small capitalization. You can further divide domestic stocks into growth and value styles. Bonds are typically divided in terms of short, intermediate and long-term duration. For the real estate component, you can use a REIT or real estate investment trust.
By establishing and maintaining a multi-asset class investment portfolio, you can reduce the overall volatility of your portfolio. It is important to understand, however, that even a well-diversified investment portfolio is subject to volatility over the long run. This is the price you pay for investing in the capital markets. The following five-step process describes how you can implement a successful investment plan to accumulate money for retirement or to achieve other financial goals:
1. Analyze Your Current Position: The investment planning process begins with a thorough understanding of your current situation and future needs. This is where you will examine and asses your own ability to tolerate market volatility. Once you understand your own profile, you can apply this knowledge to the risk and return statistics of the various assets that will be included as part of your investment portfolio.
2. Design the Portfolio: The asset allocation decision is by far one of the most important decision made by an investor. Based on the information gathered in step one, you can begin to develop your portfolio’s asset allocation. The allocation is very dependent on four factors: risk tolerance, asset class preferences, time horizons of major disbursements, and the expected returns.
3. Develop Your Investment Plan: The Investment Plan provides the policies and procedures for making investment decisions. These policies help to take your emotions out of the investment process to insure the continuity of your investment strategy, especially in volatile markets. The Investment Plan also provides a baseline from which you can monitor the performance of the overall portfolio, as well as the performance of individual money managers.
4. Implement Manager Search and Selection: Investment returns and risks are largely determined by asset allocation decisions. This will include decisions regarding active versus passive investment strategies and portfolio structure. After you complete steps one through three, you can search for and select the appropriate investment managers.
5. Monitor the Portfolio: Once the portfolio has been designed and the investment plan prepared and implemented, the final critical step is the ongoing monitoring of your investment plan. In this step, you will follow the performance of your portfolio over time and make decisions about terminating and replacing under performing investment managers when appropriate, update the asset allocation and rebalance your portfolio over time.
Investing is a serious matter. By adhering to a systematic process as described above, you will improve your chances of achieving all of your financial goals and objectives.
Bill Griffith, Jr., CFP®
is principal of W.E.
Griffith & Associates, LLC,
a wealth management firm near Pittsburgh, Pennsylvania. He has been
providing specialized strategies and services for ensuring long-term
financial independence and security for many years. He has written
numerous articles about various topics relevant to personal finance,
retirement and investment planning and is author of the books
Securing
a Retirement Income for Life
and
More
Money for Retirement Right Now.
