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Say it out loud. Doesn't it sound great?

These days, in the context of your portfolio, "cash" can be one of the most comforting words of all. It's soothing, cool, refreshing, relaxing, like a fresh ocean breeze on a hot summer day. It gives you complete peace of mind -- if you're in cash, you can tune out the market's daily lurches and stumbles, ignore the screaming on CNBC, relax, and revel in safety and comfort.

Or so you might think. Actually, you're taking a lot of risk.

Wait. What?
Nope, that wasn't a typo. If you're investing for the long term, being 100% in cash is more likely to be risky than holding some stocks, because of the gains you're likely to miss. Think about it from a longer-term perspective: On average, since the 1920s, the market has returned roughly 9%-10% a year. Unless interest rates get really crazy, you're not going to see that kind of return from a money market fund or CD. And you certainly won't see it on any kind of sustained basis.

I talked to a woman recently who had put her retirement accounts in cash in the wake of the 1987 market drop, and left them in cash for a decade. She was acutely aware of how much money she'd lost in the interim -- an investment advisor had figured it out as part of (successfully) persuading her to move to a more diversified portfolio.

Let's just say it was a large number.

If you're sitting in cash right now, I'm assuming that you're still seriously worried about the near-term direction of the stock markets. That's fine -- obviously you don't have to plow all that cash right back into the stock market today in order to avoid that woman's fate. But you should have a plan in place for getting back in. And if you're really concerned about risk (and who isn't?), it's time to get serious about asset allocation.

Add risky investments, lower your risk
Asset allocation is a pretty simple concept. You're probably already familiar with it: In a nutshell, by spreading your investments among several different asset classes, you take advantage of the fact that different corners of the market show strength at different times, while minimizing your exposure to weakness that might hit one of those corners particularly hard.

At the simplest level, asset allocation is pretty easy: Own some bonds along with some stocks, and increase the ratio of bonds to stocks as you get older. That was the conventional wisdom decades ago. But the science has advanced a bit since then, and nowadays we focus mostly on stocks -- and we divide the universe of "stocks" into several different segments.

Consider, for instance, these segments, with examples of representative stocks in each:

  • Large-cap powerhouses like Novartis (NYSE: NVS  ) and 3M (NYSE: MMM  ) .
  • Value-priced small-caps like Manitowoc (NYSE: MTW  ) and Precision Drilling Trust (NYSE: PDS  ) .
  • Big-growth possibilities like up-and-coming meat producer Sadia (NYSE: SDA  ) and Spidey-lover Marvel Entertainment (NYSE: MVL  ) .
  • Foreign stars like Chinese energy firm CNOOC (NYSE: CEO  ) .

The idea is that by combining mega-cap blue chips and promising small-caps, U.S. and foreign stocks, and value and growth prospects, we end up with a portfolio that's more than the sum of its parts, because the risks of the different asset classes offset one another to some extent.

Specifically, by adding the more volatile -- riskier -- types of stocks to our holdings in things like bonds and big boring blue chips, the overall volatility of the portfolio actually goes down -- as long as you stick with the strategy (namely, "don't sell everything and sit in cash") through the market's ups and downs.

How is this possible?

The recipe is the secret
In the new issue of the Fool's Rule Your Retirement newsletter, available online at 4 p.m. EST today, lead advisor Robert Brokamp lays it all out, starting with this observation: Risk is the foundation of higher returns. Working from there, and drawing on observations from asset manager (and Fool favorite) Larry Swedroe as well as financial-theory giants Eugene Fama and Kenneth French, Robert shows exactly how to use riskier types of stocks to lower the overall risk level of your portfolio.

This is a big deal -- whether you're sitting in cash right now or you've held stocks through the downturn, reworking your portfolio along these lines can help insulate you from further losses while positioning you for solid gains. That may sound impossible, but it's time-tested truth. Robert's article shows you how to make it happen -- and the newsletter's excellent asset-allocation templates give you a complete road map for your long-term holdings.

It's all here in the new issue of Rule Your Retirement. Not a subscriber? A free trial gives you full access to the new issue plus all of the Rule Your Retirement resources for 30 days, with absolutely no obligation. Click here to get started.

Fool contributor John Rosevear has no position in the companies mentioned. Precision Drilling and CNOOC are Motley Fool Global Gains recommendations. Sadia is a Motley Fool Hidden Gems selection. 3M is a Motley Fool Inside Value pick. Marvel Entertainment is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 05, 2009, at 4:21 PM, dsk315 wrote:

    The only problem is, 2008 has shown asset allocation does not work. I agree with Randy Swan's take on asset allocation. He wrote, "the risk reduction is strictly theoretical (typically based upon relationships that existed over a particular period with no guarantee that these same relationships will continue in the future). This is the crux of where asset allocation or modern portfolio theory breaks down. Risk is not defined; instead it is merely expressed in historical standards."

    However, I agree that investors need risk in thier portfolio to generate returns. No risk = no reward. I just think that most people will want to define risk in more absolute terms instead of historical measures.

  • Report this Comment On February 06, 2009, at 12:30 AM, CoastalTrader wrote:

    Good point dsk315. What precisely is "risk"? Is it just losing your money -- going to zero, or is it volatility?

    Or is it a combination of both things?

  • Report this Comment On August 18, 2009, at 4:00 AM, DynamicGlobal wrote:

    In 2008, the cry has gone up from investors around the world, “What the hell went wrong with my portfolio? I thought I was diversified!”

    Quantitative risk analysis and traditional “efficient frontier investing” have given investors a false sense of confidence, taking them down a path that, recently, led to greater losses. To better protect portfolios against large drawdowns and increase long-term returns, it is time to look beyond static portfolios and risk models to a more dynamic asset allocation.

    Every bear market leads to changes in investor behavior, and this will be no different. The question is whether investors will learn the right lessons. Investors, at all times, should ensure that that they are being appropriately compensated for the risks of investing into various asset classes.


    Risk Control. Aims at maintaining the

    investment within a pre-set risk budget; and

    Dynamic Allocation. Reduced exposure in turbulent and bearish market conditions.

    While diversifying your portfolio of risk assets will reduce price risk under many circumstances, it does not change the fact that they remain risk assets. It makes sense to go beyond diversification in risk assets and dynamically allocate, both in terms of risk, and what the overall allocation to risk should be.

    Rather than having a static allocation to each class of risk asset, it makes more sense to keep all of them on the menu.

    Having a Risk Budget (or a Volatility Benchmark) means that if your portfolio becomes too highly correlated and/or the assets become too volatile, you will be forced to reduce exposure to these assets accordingly.

    In 2007/2008, traditional asset allocation Funds that seemed secure against any eventuality have been crumbling in the onslaught of the recent bear market, and many investors have realised that their carefully crafted risk control measures have failed.

    The standard case for diversification can be summarised as: (1) financial assets have return patterns that are not completely correlated to one another; and (2) a well-constructed portfolio consisting of a number of imperfectly correlated assets can reduce overall risk without reducing expected returns.

    Of course, when all the assets become highly correlated (as in 2007 and 2008), then a static asset portfolio no longer remains decorrelated to the underlying assets (and thus increases the risk exponentially).

    However, in our dynamic and risk controlled world our set of rules (constraints) limits the weighting to the various assets, which prevents too high a correlation on one asset.

    Furthermore, we dynamically shift our allocations on a monthly basis taking into account risk, returns and correlation. In this manner we are able to remain decorrelated to traditional assets.

    What has become apparent under recent market conditions is that traditional asset allocation methods have failed and highlights why we believe investors need to reassess the virtues of diversification among risk assets.

    To better protect portfolios against large drawdowns and increase long-term returns, it is time to look beyond static portfolios and risk models to a more dynamic asset allocation.

    The traditional asset allocation community have only recently realised that their static portfolios and risk models have not protected their portfolios against large drawdowns and need more dynamic asset allocation. This means they are already starting to look at applying similar principles within their portfolios to provide better protection in future scenarios.

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