Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. 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 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, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable 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. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
Risk versus Reward
When it comes to investing, risk and reward are inextricably entwined. You’ve probably heard the phrase “no pain, no gain” – those words come close to summing up the relationship between risk and reward. Don’t let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchases securities – such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your 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 rather than restricting your investments to assets with less risk.
Investment Choices
For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let’s take a closer look at the characteristics of the three major asset categories.
>Stocks – Stocks have historically had the greatest risk and highest returns among the three major asset categories. Stocks are a portfolio’s “heavy hitter,” offering the greatest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a very risky investment in the short term. But investors that have been willing to ride out the volatile returns of stocks over long periods generally have been rewarded with positive returns.
>Bonds – Bonds are generally less volatile than stocks but offer more modest returns. An investor approaching a financial goal might increase his or her bond holdings because the reduced risk of holding more bonds would be attractive despite their lower potential for growth. You should keep in mind that certain bonds offering high returns, known as high-yield or junk bonds, also carry higher risk.
Cash – Cash and cash equivalents – such as savings deposits, CD’s, treasury bills, and money market accounts – are the safest investments, but offer the lowest return. The principal concern investing in cash equivalents is inflation risk that could erode investment returns over time.
Stocks, bonds, and cash are the most common asset categories. But other asset categories – including real estate, precious metals and other commodities, and private equity – also exist, and some investors may include these asset categories within a portfolio. 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 with investment returns that move up and down under different market conditions, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. 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. If one asset category’s investment return falls, you’ll be in a position to counteract your losses with better investment returns in another asset category.
In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it.
How to Get Started
Determining the appropriate asset allocation model for a financial goal is a complicated task. Basically, you’re trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. As you get closer to meeting your goal, you’ll need to be able to adjust the mix of assets.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.
Some financial experts believe that determining your asset allocation is even more important than the individual investments you buy. With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future.