What is asset allocation and what role do index funds play in asset allocation?
Asset allocation is the process of dividing investments among different kinds of assets, such as stocks, bonds, real estate, and cash, to optimize the risk/reward tradeoff based on an individual’s specific situation and goals. In 1986, Gary Brinson published in the Financial Analysts Journal his famous paper on asset allocation titled Determinants of Portfolio Performance. Brinson found that asset allocation, not the specific stocks in a portfolio, were the key determinant in the return of the portfolio. Brinson found that asset allocation explained over 90% of a portfolio’s return. His findings were subsequently confirmed by other researchers (Ibbotson and Kaplan, 2000; The Vanguard Group, 2003). One method of using asset allocation is to first determine what percent of your portfolio should be invested in stocks, bonds, real estate, and cash. Index mutual funds, or ETF’s can then be used as a very low cost way to invest your portfolio in stocks, bonds, or real estate. See The Coffeeh
