Market Wrap-up for Oct. 26 – It’s Not About What Stocks You Buy

Whenever we are reminded of Wall Street success stories, take for example Warren Buffett, we instinctively link the individual’s great accomplishments to their stock-picking abilities. But the bigger reason, which is far less talked about, as to why some investors have managed to outperform the market over the long-haul lies in their planning ability more so than their knack for picking winning stocks.

That is to say, the so-called “secret to success” in the market has more to do with your asset allocation strategy, and actually sticking to it, than it does with your ability (or dumb luck) to pick the next hot stock on Wall Street. The reality is that this truth is far less appealing at first glance (it takes more work too) and many would much rather believe they too can beat the market by simply outsmarting or “out-picking” the rest of the crowd.

Asset Allocation 101

If you’re not familiar with this concept, take a step back and educate yourself on it because it’s absolutely one of the most important things that all successful investors utilize; the SEC offers a great Beginner’s Guide to Asset Allocation, as does Franklin Templeton Investments. Simply put, asset allocation refers to how you will divide up your capital among the major categories, which for simplicity’s sake are stocks, bonds, and cash-equivalents.

How you divide up your capital is largely dependent on two factors:

Your Goals - Are you saving for retirement down the road? Are you retired and looking to generate income? The investment process needs to start with you asking yourself what you want to accomplish; only then can you formulate a game plan that will help you align the present and the future. That is to say, you need to have a clear cut financial goal in mind for the future, which will ultimately help to influence and guide your money management decisions in the present.  Your Risk Tolerance - Depending on your goal and your investment horizon (in years), you will need to define your own risk tolerance. This refers to how much risk you are comfortable with undertaking so that you may still accomplish your longer-term goal. Breaking it down even more, this decision will help steer your allocations; if you’re nearing retirement, then bonds will likely make up a larger chunk of your portfolio. Likewise, if you’re a 20-something young professional, you should ideally set aside a greater portion of your assets for equity investments [see 7 Retirement-Planning Musts for Young Investors].

In the end, the point of an asset allocation strategy is to remind yourself of your longer-term goals to ensure that the portfolio management decisions you make today align with your objective and risk-tolerance. For example, if you’re committed to steadily growing (or preserving) your retirement account, there’s no temptation to gamble with penny stocks or hot IPOs today because your asset allocation strategy will remind you to steer away from certain opportunities, as they fall outside of your risk tolerance and don’t contribute to your future objective.