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Asset Allocation Strategies

The Risk of Ruin and the 5 Steps To Proper Asset Allocation

Written by Brian Hicks
Posted June 12, 2008

If you have ever been to Vegas, it doesn't take too much time standing around a Black Jack table before it hits you. You realize that for a really good player, Black Jack is actually one of the games that can be beaten.

Of course, that's easier said than done. For most people it is an exercise in futility, like the rest of the games there.

But part of what makes a good Black Jack player so good, is concept known by every gambler worth his salt. It's called the risk of ruin, and it's the undercurrent that is behind asset allocation strategy.

To gamblers, however, the risk of ruin refers to the possibility that a string of losses will wipe them out entirely. That of course, is completely unacceptable since those chips are their ticket to the game.

No chips, in other words, means no game. And the "free" drinks aren't exactly what draws in the good players.

The Risk of Ruin Explained

Take, for instance, the following simple gambling scenario and the risk that it entails.

Suppose I said I would give you $2 for every $1 you bet if we rolled a single die and it came up 4, 5, or 6. If you though about it you would want to bet as much as you could.

That's because the odds of winning are even and the payoff is double the risk. So in four rolls, if you bet a $1 each the odds are that you would win twice and lose twice. Your gain then would be $2.

That sounds good right? Well sort of.

The problem is that if you started with only $10, there is a chance that you could lose it all—even though the odds are in your favor.

For instance, you could bet $5 on the first two rolls and be wiped out in short order. After all there is a 25% chance that there will be two losing rolls in a row.

That means that there is a 25% "risk of ruin" inherent in that particular strategy. That's not good if you want to keep on playing.

And here's the thing, if you haven't figured it out already—the higher your bet is on an individual roll, the higher your risk of ruin becomes. One string of losses on big bets, in other words, can prematurely end your game.

So a good black jack player is one that plays conservatively, waiting for the moment when the odds swing against the dealer. That takes patience, but the rewards often out weigh the risks to the few that understand this concept.

And it's no different really when you are trying to make money in the stock market.

The good news is that on Wall Street, it is a hundred times easier to win than against a Vegas dealer.

The key, however, is exactly the same: You have to limit your risk of ruin.

The Asset Allocation Strategy and the Winning Hand

That means you have be diversified at all times, and you have to stick to your stops. After all, as I alluded to earlier your principal is your ticket to the game. It needs to be defended at all times.

Of course, asset allocation doesn't always mean the same thing for every investor.

To an investor with a smaller principal it may mean bets on only 4-5 stocks, while a much larger portfolio my hold as many as a dozen. The risks are simply different.

But before you assemble anything, the risk of ruin is concept that you need to get your head completely around. It's the difference between winning and losing over the long haul.

Losses, after all, are part of the game-even for the best players. How you plan to deal with them is what counts.

In other words, you need to be spread out your risks if you want to play in the long run. Proper asset allocation is the key to this strategy.

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Here's How This Asset Allocation Strategy Works

An investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated. That could include either equities from different sectors or a mix of investments ranging from stocks to bonds, commodities and cash.

That is known as a vertically diversified portfolio. It's quite different from its cousin, the horizontally diversified portfolio.

In contrast, horizontally diversified portfolios are investments within one asset class or sector. It's not the same thing.

For instance, while you may own as many as 6 different tech stocks, your diversification in this case is minimal. After all, one bad string of months on the NASDAQ would likely drag them all down. That's exactly the scenario that you are trying to avoid.

Instead, you need to allocate your assets across different areas of the markets. In this strategy, you are protected against a massive pullback in one area of your portfolio.

Asset Allocation and You

Of course, the process of figuring out which mix of assets to hold in your portfolio is a very personal one. That's because no two investors are exactly a like.

The type of asset allocation strategy that works the best for you then will depend largely on your time horizon and your ability to tolerate risk.

Here's a look at both of them and what you may need to consider as weigh your options.

  • Time Horizon - Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager's college education would likely take on less risk because he or she has a shorter time horizon.
  • Risk Tolerance - Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment.

So in the words of the famous saying, conservative investors aim to keep the "bird in the hand," while aggressive investors seek to gain the "two in the bush."

How you play it, of course, is up to you.

Nonetheless, here are the top 5 things to know about asset allocation:

1. Time is on your side- Those with more years until retirement can afford to put a greater percentage of their assets in the stock market.

2. Stocks mean risk and return-Those with a higher tolerance for volatility should put more money in the stock market than those in the same age group who have a lower tolerance.

3. Allocation is the key to achieving your goals- Studies have shown that asset allocation is the single most important factor in determining returns from investing.

4. Determine your long-term goals- Do you want to buy a sailboat after you retire? Or pay off your mortgage so you can write a novel? Figure out what your long-term goals are, and what they will cost. Then build a plan to achieve them.

5. Get started- It's never too late to get started, and it's never too late to revamp or revise an asset allocation plan.

So with the market storm beginning to blow again, don't wait until its too late to batten down the hatches of your portfolio. Diversify your holdings and eliminate your risk of ruin.

Your bargain-hunting analyst,

steve sig

Steve Christ

Chief Investment Analyst

The Wealth Advisory

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