Securities Regulator Provides Helpful Guidance As To
Asset Allocation, Diversification and Rebalancing
The Securities and Exchange Commission (SEC) has published a “Beginners’ Guide” to
important investment portfolio strategies that is most helpful for the beginner as well as the more
advanced investor (and their financial advisers). The guidance is found at
Why is the guidance so helpful? The SEC finds “magic” in diversification: “By picking
the right group of investments, you may be able to limit your losses and reduce the fluctuations
of investment returns without sacrificing too much potential gain.” Let’s overview the key
Asset allocation involves dividing your investments between different categories of
assets, such as stocks, bonds and cash. The SEC advises that the right asset allocation largely
depends on two factors: time horizon and risk tolerance. Time horizon is critical because an
investor with a long term time horizon better can withstand the ups and downs of the stock
market and the economy. However, investors with short term time horizons do not have that
luxury. That may be the case with investors who are soon to retire, needing income, or saving
for their children’s college education. For those investors, investing in cash and bonds (with a
relatively small allocation to stocks so as to offset the effects of inflation) may be the only
appropriate asset allocation.
The second factor is risk tolerance. Importantly, the SEC states that risk tolerance is not
only an investor’s willingness to take on risk, but also an investor’s financial ability to take on
risk. The SEC comments that conservative investors seek the “bird in the hand”, while
aggressive investors tend to lose money in the stock market as they seek the “two in the bush.”
The SEC describes the basic attributes of stocks, bonds and cash. Notably, regarding
stocks, the SEC states that the “volatility of stocks makes them a very risky investment in the
short term.” Regarding bonds, the SEC opines that investors approaching their financial goals
may want to increase their bond holdings because they carry less risk than stocks. On the other
hand, bonds offering high returns, known as “high yield” or “junk” bonds, carry high risk.
Finally, cash – and cash equivalents like CDs, treasury bills and money market deposits – are the
safest but offer the lowest returns of the three asset categories.
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There are other asset categories, as the SEC recognizes, like real estate, precious metals,
commodities and private equities. These carry their own “category-specific risks” and the SEC
cautions investors to understand the risks of those investments before investing.
The Importance of Asset Allocation and Diversification
The returns of each of the three major categories have not moved up and down at the
same time, the SEC observes. As a result, it is prudent to invest in more than one asset category.
Investment research has demonstrated that this strategy not only reduces risk, but also can
Investors also must understand the concept of diversification. Asset allocation to stocks
must also include diversification among stocks. It may not be sufficient to own a mutual fund of
many stocks, because many of those stocks may be in the same industry, say technology. So,
investors need to diversify among sectors, which themselves may perform differently from each
other under various market and economic conditions.
Rebalancing is a necessary process. Investors, and their financial advisers, need to bring
the asset allocation back to the original asset allocation mix. This is most important when the
investments become “out of alignment with your investment goals,” according to the SEC. The
SEC advises that rebalancing occur either on a time basis – every six to twelve months – or on an
asset weighting basis – when one asset class (or industry sector within the stocks asset class)
increases or decreases by more than a certain percentage.
To illustrate these concepts, the SEC furnishes a nifty on-line financial calculator.
Investors can input their age, current assets, savings per year, income required, marginal tax rate,
risk tolerance and economic outlook. They then immediately receive a suggestion as to the right,
balanced investment portfolio. It’s worth trying as investors may be surprised at what is best for
About the Author: James J. Eccleston leads the Securities group at the Chicago law firm of Shaheen, Novoselsky,
Staat, Filipowski & Eccleston, P.C., where he represents investors in recovering investment losses and financial
services professionals in disciplinary, employment, and compliance matters. He has held numerous securities
licenses and Chicago Bar Association leadership positions and serves as an arbitrator and mediator. He is a
recipient of Martindale-Hubbell’s highest rating (AV) for legal ability and ethics and is named to the Illinois Super
Lawyer and Leading Lawyer lists.
JEccleston@snsfe-law.com, 312.621.4400, www.snsfe-law.com, www.financialcounsel.com
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