Thanks to Brian O’Connell at the Street.com for the opportunity to discuss our thoughts on asset allocation (here). Ask any investment specialist, and you’ll get an earful on how determining your asset allocation is one of the most important investment decisions you make. By and large, they’ll say, asset allocation is likely to have a bigger impact on the performance of a portfolio than the selection of individual investments. So, what exactly is asset allocation? Asset allocation is the process of balancing risk and return in a portfolio by investing across different asset classes. The major asset classes include: stocks, bonds, cash, and alternative investments (think commodities or options contracts, for example.) Historically, the traditional investment portfolio is a 60% allocation to stocks and a 40% allocation to bonds. Recently, however, there’s been an active discussion if the 60% – 40% asset allocation model is on the way out – deader than the Boston Red Sox in the American League East this summer. Recently, the Kitchen Table Economist engaged with Chad Hamilton, director of practice management at Brown and Company in Denver, Colo. Here’s what he had to say about asset allocation and the 60-40 allocation model. KTE: Why is asset allocation so important in investing? Hamilton: While you cannot control the performance of the stock market, you can control how you allocate money to different types of investments (i.e., stocks, bonds, cash, etc.). Since each of these various investment types has a different level of risk (or volatility), asset allocation is a way to align your tolerance for risk with the way in which you invest. KTE: Most Main Street savers have their money in retirement plans. How do you develop an Asset Allocation plan for an IRA or 401(k) plan? Hamilton: The best way to do this is to start with a comprehensive financial plan so that you have an understanding of your time horizon, personal financial goals, income needs, and tolerance for risk. Then, based on these different factors, you can determine the most appropriate allocation for your situation. We use what we call our Withdrawal Stress Test to help determine the proper allocation. The idea is that the higher your withdrawal rate (the need for cash flow as a percentage of the portfolio), the greater rate of return you will need from your investments. Whereas, with a lower withdrawal rate (below 4%), you have more flexibility to invest either more aggressively or more conservatively.KTE: What’s the difference between strategic asset allocation and tactical asset allocation? Hamilton: Strategic asset allocation means that you set targets of, say, 60% to stocks and 40% to bonds and you stick with that and do not change it regardless of market conditions. To the extent that changes in values fluctuate, you periodically rebalance back to the target. Tactical asset allocation is an active approach to investment management that will intentionally overweight or underweight different types of investments based on the market environment. As an example, last year we adjusted our clients’ portfolios by taking some chips off the table by scaling back our allocation to stocks and adding it to short term bonds and cash. We made this tactical adjustment because we were more than a decade into one of the longest bull markets in history and decided it would make sense to create some cash for future buying opportunities in the event of a market downturn. KTE: Is the 60% – 40% asset allocation model cooked? Hamilton: No, the 60/40 asset allocation is not dead. I realize this is not the most exciting response, but it’s much more about what is owned within the 60/40 allocation than disparaging the approach itself – especially what types of stocks or stock funds you own within the 60% and what types of bonds you own within the 40% categories. I’ve been in the investment industry for more than 20 years, and I’ve never seen a wider gap in performance based on sector, industry, and company size than we’re seeing right now. You can see this by looking at the makeup of the S&P 500. The top five stocks in the S&P 500 are huge, familiar technology firms that have done exceedingly well this year and are up around 40% year-to-date. The rest of the S&P 500 – the other 495 companies in the index – are down slightly year-to-date. The largest firms, the biggest brands, and the companies with the strongest balance sheets and staying power are faring extremely well, while so many other smaller firms are struggling to survive. KTE: Thanks for your time. Hamilton: You bet.