The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, account for most of the ups and downs of a portfolio’s returns.
Deciding how much of each you should include is one of your most important tasks as an investor. That balance between potential for growth, income, and stability is called your asset allocation. It doesn’t guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.
Balancing risk and return
Ideally, you should strive for an overall combination of investments that can help to minimize the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. Your financial professional tells you that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn’t be seen as definitive. Your asset allocation is–or should be–as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances.
Many ways to diversify
When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don’t necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies, or allocate based on geography. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.
Monitoring your portfolio
Even if you’ve chosen an asset allocation, market forces may quickly begin to tweak it. For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want. If they go down, you might worry that you won’t be able to reach your financial goals. The same is true for bonds and other investments.
Do you have a strategy for dealing with those changes? Of course you’ll probably want to take a look at your individual investments, but you’ll also want to think about your asset allocation. Just like your initial investing strategy, your game plan for fine-tuning your portfolio periodically should reflect your investing personality.
Even if you’re happy with your asset allocation, remember that your circumstances will change over time. Those changes may affect how well your investments match your goals. At a minimum, you should periodically review the reasons for your initial choices to make sure they’re still valid. Also, some investments, such as mutual funds, may actually change over time; make sure they’re still a good fit.
Note: Asset allocation and diversification don’t guarantee a profit or insure against a loss. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
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