Portfolio Allocation 101
Five years from now, there’s going to be one investment that did better than any other, and of course, you don’t know what that investment will turn out to be. Due to this issue, the desire to come up with an ideal asset allocation is a strong one. Given that we don’t know the future, what guidelines can we use to make our investment decisions?
The Basics: Asset Allocation:
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Time Horizon – Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier investment because he or she can wait out slow economic cycles and the ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
Risk Tolerance – Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment.
Risk versus Reward
When it comes to investing, risk and reward are entwined. All investments involve some degree of risk. If you intend to purchases securities – such as stocks, bonds, or mutual funds – it’s important to understand that the potential exists to lose money.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.
Investment Choices
A vast array of investment products exist – including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. However, there are three major ones to consider:
Stocks - Stocks have historically had the greatest risk and highest returns among the three major asset categories. As an asset category, stocks are a portfolio’s “heavy hitter,” offering the greatest potential for growth.
Bonds - Bonds generally contain less risk than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth.
Cash - Cash and cash equivalents – such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds – are the safest investments, but offer the lowest return of the three major asset categories. Generally speaking, the chances of losing money on an investment in this category are extremely low.
These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan. But before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.
Why Asset Allocation Is So Important
By including asset categories that behave differently under varying market conditions, an investor can protect against significant losses. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride.
The Magic of Diversification
The practice of spreading money among different investments to reduce risk is known as diversification. By picking a diversified group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal.
By having a good portfolio, you are already one step closer to planning a safe retirement. To take a few more steps closer to an even safer retirement, check out our Retirement Calculator.
