A Careful Look at Asset Allocation Tools
By: Jeff Brown

You find them all over the Internet, especially on mutual fund and brokerage sites: questionnaires and calculators to help you divide your portfolio among stocks, bonds and cash.

But can you trust them?

Sure, as long as you don’t take their advice too literally. No automated system can perfectly tailor its results to your situation, or predict exactly what will happen in the real world.

Any basic asset allocation tool, like the one provided by the market-data firm Morningstar Inc. (Stock Quote: MORN), can help you figure how to divide up your portfolio. Some break the categories down further, suggesting allocations to big, medium, and small-company stocks, as well as foreign and emerging market stocks.

In the bond category, they’ll suggest percentages for long-term, mid-term and short-term bonds, junk bonds, foreign bonds and so forth. (For cash, they just assume you’ll pick your own certificate of deposit (CD), money market, or savings account.

Typically, these tools suggest that 20 and 30-somethings put the bulk of their long-term holdings into stocks or stock mutual funds, since young investors have time to weather downturns and enjoy stocks’ historically superior long-term gains.

Since a big stock downturn on the eve of retirement can be devastating, older investors are told to put more into bonds and cash, such as CDs, savings and money market accounts and funds.

Most good asset allocation tools, like the one from the mutual fund company Vanguard Group, include a questionnaire to tailor the results to the user’s situation.
This usually includes a probe of one’s “risk tolerance” with questions like, “What would you do if your stocks lost 30 percent of their value?”

If you would sell them all and move into cash, the tool concludes you are “risk averse” and recommends a more conservative portfolio heavy on bonds and cash. But if you say you’d see a downturn as a buying opportunity, it will conclude you have the nerve for more risk and urge a bigger stock allocation.

Unfortunately, online allocation tools simply take your responses at face value, doing nothing to correct your misconceptions. A human advisor might point out that a 20-something investor terrified of a downturn is overreacting, and the advisor might propose a more cautious approach to the 70-year-old who wants to day trade.

In another limitation, allocation tools assume that past performance indicates how various types of holdings will perform in the future. Many also assume annual returns will be the same year after year: stocks at 10 percent, bonds at 5 and cash at 3, for instance.

While that may accurately reflect the long-term averages, results fluctuate in the real world. If the stock market drops 25 percent just as you begin retirement, you could be in trouble, even if it does average 10 percent annual gains over the following decade.

Also, if the market drops, you might trim your budget in order to increase your investment contributions to regain lost ground. Or you might plan to retire at 68 instead of 65. Allocation tools can’t account for these course corrections.
To get better results, take several runs through any allocation tool, varying your inputs from best- to worst-case possibilities.

Also, try a Monte Carlo simulator, such as the one offered by T. Rowe Price, (Stock Quote: TROW) the fund company. These use hundreds of input variations, sometimes thousands, to figure the odds you’ll meet your financial goals.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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