If you can follow that logic, you’re off to a terrific start in your pursuit of asset allocation and diversification. These themes will be explored further in this article, which will also highlight the value of periodic re balancing.
First, we’ll examine asset allocation.
Investing Fundamentals of Asset Allocation
Asset allocation is the process of determining how stocks, bonds, and cash will be distributed across a portfolio. Selecting a portfolio’s asset allocation is a highly individual procedure. Your time horizon and risk tolerance will play major roles in determining the asset allocation that is optimal for you at any given moment in your life. If you don’t have the time or expertise to do it yourself, you can always seek the assistance of a professional portfolio management service.
Horizon of Time
For any given investment, your time horizon is the estimated number of months, years, or decades it will take you to reach your end goal. Because they have more time to ride out the inevitable ups and downs of our markets and slow economic cycles, investors with longer time horizons may feel more comfortable taking on riskier, more volatile investments.
Can You Take the Risk?
One’s risk tolerance determines whether or not they are prepared to risk losing all or a portion of their initial investment in pursuit of higher returns. An investor with a high risk tolerance, sometimes known as “aggressive,” is more willing to take a chance and potentially lose money in order to achieve greater gains. An investor with a low risk tolerance, typically seeks for safe investments designed to protect capital.
Probability and Payoffs
The potential for financial gain and loss are inseparable when it comes to investing. The saying “no pain, no gain” comes close to summarizing the connection between risk and return, and you’ve probably heard it before. In spite of what some may say, this is the case. There is always an element of danger when putting money into the stock market. A buyer of stocks, bonds, or mutual funds should know that there is a risk of losing some or all of their investment.
The possibility for a higher investment return is the payoff for taking on risk. Investing prudently in higher-risk asset categories, such as equities or bonds, can produce higher returns over the long term than investing only in lower-risk asset categories, such as cash equivalents, if you are saving for a long-term financial objective. However, if your financial goals are more immediate, sticking to cash investments may be the best option.
Potential Investments
The SEC cannot endorse any specific investment vehicle, but you should be aware of the wide variety of investment vehicles available, such as stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and Treasury securities.
Diversifying your investment portfolio among stocks, bonds, and cash can be a useful tactic for achieving a variety of financial objectives. Let’s examine the differences between these three types of assets in more detail.
Stocks
When compared to the other two major asset classes, stocks have always carried the greatest potential for loss, but also produced the biggest potential rewards. Stocks have the greatest potential for growth and are hence the “heavy hitter” of a portfolio. Stocks can both soar and tank. Stocks are a risky short-term investment due to their high volatility. For instance, over one-third of the time, investors in large-cap stocks have actually lost money. And there have been occasions when the casualties were particularly high. However, long-term investors who can stomach the ups and downs of the stock market have historically been rewarded handsomely.
Bonds
Bonds are less risky than stocks but are not beneficial as much. Since the lower risk of holding more bonds would be appealing to the investor despite the lesser potential for growth, the investor might increase his or her bond holdings relative to the stock holdings as the investor nears a financial objective. Keep in mind that some types of bonds offer returns on the same order as stocks. High-yield bonds, commonly called junk bonds, provide a higher yield but also a higher risk.
Cash
Among the three primary asset classes, cash and cash equivalents (such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds) are the safest assets but also provide the lowest return. Losing money on an investment in this sector is a very remote possibility. Losses on investments in things that aren’t cash are rare, but they do happen. Inflation risk is the primary consideration for investors holding cash equivalents. That earnings on investments will be gradually eroded by inflation is the risk we run.
Most people’s assets consist of stocks, bonds, and cash. When putting money away for retirement or college, these are the types of investments you’re probably considering. The real estate market, precious metals and other commodities, and private equity are just a few examples of other asset categories that some investors may choose to incorporate in their portfolios. In general, these types of investments are subject to dangers unique to their class. Investing involves risk, and you should not get in without first doing your research to make sure you’re comfortable with the level of risk involved.
The Importance of Asset Allocation
To mitigate the risk of catastrophic loss, a diversified portfolio should contain a variety of asset classes whose investment returns fluctuate with market conditions. For the most part, the three main types of asset returns have neither risen or fallen together in the past. When one type of asset does well due to market conditions, it usually means that another type of asset performs averagely or poorly. If you spread your investments among several types of assets, you can lower your portfolio’s overall risk and improve the consistency of your investment results. It allows you to offset losses in one asset class with gains in another.
The Power of Variety
Diversification is the process of spreading money out among many investments to lessen overall risk. With careful portfolio construction, you may be able to dampen the gyrations of your investment returns and protect yourself against catastrophic loss without giving up too much upside potential.
Additionally, asset allocation is critical since it greatly affects the likelihood that you will succeed in reaching your financial objective. It’s possible that your portfolio won’t generate a high enough return if you don’t expose yourself to enough risk. Yet, if you expose your portfolio to too much uncertainty, you run the danger of having insufficient funds to reach your objective at the time you really need them.
The First Steps
It can be difficult to select the best asset allocation strategy when trying to achieve a specific financial objective. To put it simply, you want to select a portfolio that maximizes the likelihood of achieving your goal within a comfort zone of risk. You’ll want the flexibility to shift your asset allocation as you move closer to your target.
You may feel confident designing your own asset allocation model if you understand your time horizon and risk tolerance and have some investing expertise. There are a number of resources available online and in books that provide “how to” guidance on investing, and many of these provide basic “rules of thumb” that may be applied to a variety of situations. Despite the fact that the SEC cannot recommend a specific formula or approach, the Iowa Public Employees Retirement System (www.ipers.org) provides a web-based asset allocation calculator. Ultimately, it will come down to a decision that is deeply personal to you. There is no universally applicable asset allocation strategy. Choose the one that works best for you.
Financial professionals disagree on which is more crucial: the assets themselves or the asset allocation strategy that determines how those investments should be weighted. For this reason, it’s a good idea to see a financial advisor for assistance in setting up your initial asset allocation and making any necessary revisions going forward. Do your due diligence before enlisting anyone’s assistance with such life-altering choices.
Diversification and Asset Allocation: A Closer Look
The old proverb “don’t put all your eggs in one basket” captures the essence of diversification. The idea behind diversification is that your portfolio as a whole will perform better than any individual holding, allowing you to weather the losses of any single investment.
Asset allocation is used by many investors as a means of diversifying their holdings across several asset classes. But there are also investors who choose not to. A twenty-five-year-old saving for retirement could do well to put all of their money into stocks, while a family saving for a down payment on a house might do better to put all of their money into cash equivalents. Neither method, however, seeks to lessen exposure to danger by diversifying the types of assets held. Portfolio diversification is not guaranteed by the use of an asset allocation model. Your portfolio’s level of diversification depends on the extent to which your funds are allocated among various investment options.
Basics of Diversification
A well-balanced portfolio will have a wide variety of investments both within and across asset classes. You should diversify your holdings not only among stock, bond, cash equivalent, and other investment options, but also across several sub-classes within each of these broad buckets. The trick is to locate holdings within each asset class that have the potential to respond differently to shifting market conditions.
Finding and investing in a wide range of companies and industrial sectors is one strategy to diversify within a given asset class. However, if you invest only in four or five different stocks, your stock portfolio is not diversified. If you want to be genuinely diversified, you should own at least a dozen different equities.
Due to the difficulty of diversification, some investors may find it more convenient to buy mutual funds that invest across multiple asset classes rather than making separate investments in each asset class. To invest in stocks, bonds, and other financial products, a mutual fund pools capital from numerous individuals. Mutual funds simplify the process of owning a fractional share of a wide range of investments. As an illustration, a total stock market index fund would hold shares in hundreds of different corporations. That’s a lot of variety in a single financial commitment.
If a mutual fund invests solely in one industry, for example, that investment may not immediately provide diversity. If you’re looking for diversification but only want to invest in specialized mutual funds, you may need to buy shares in more than one fund. That may imply looking at large-company stock funds alongside small-company and foreign stock funds within the asset class. That could involve looking at mutual funds that invest in stocks, bonds, and even money markets. Of course, as your portfolio grows, you’ll probably incur more fees and expenses, which will reduce your returns. These costs must be included in when determining the optimal portfolio diversification strategy.
Variable Asset Allocation
Changing your investment horizon is the most prevalent cause for rebalancing your assets. That is to say, you should probably adjust your asset allocation as you come closer to your investing target. Towards retirement age, for instance, most people who have been saving for their future hold less stocks and more bonds and cash equivalents. If your risk tolerance, financial status, or financial goal changes, you may also need to adjust your asset allocation.
However, experienced investors rarely make adjustments to their asset allocation based on the relative performance of asset categories, such as boosting their exposure to stocks during a bull market. They “rebalance” their holdings instead.
Basics of Re balancing
Re balancing is when you return your holdings in a portfolio to how they were initially constructed. As time passes, certain of your holdings may no longer contribute to your overall investing strategy. Some of your assets are bound to outperform others. You may get your portfolio back to a manageable level of risk and make sure no asset class is over represented by performing a re balance.
Let’s imagine, for the sake of argument, that you’ve decided that stocks should account for 60% of your portfolio. Since the stock market’s recent rise, however, your portfolio is now 80 percent stocks. If you want to get back to your original asset allocation percentages, you’ll need to either sell some of your stock holdings or buy assets from an under-weighted asset category.
Each asset allocation category’s holdings should be evaluated as part of the re balancing process. Re balancing your assets back to their original allocation within the asset category may be necessary if you find that any of your holdings are no longer in line with your investing objectives.
You can re balance your portfolio in one of three main ways:
- You can utilize the money from the sale of investments in the over-weighted asset categories to buy investments in the under-weighted asset categories.
2. You can add under-weighted asset categories by the purchase of new investments.
- If you’re still putting money into the portfolio regularly, you can shift your allocation such that more of your money goes toward under-weighted asset classes.
When deciding how to re balance your portfolio, you should think about any transaction fees or tax implications that may arise. Your accountant or financial planner should be able to help you find strategies to reduce these costs.
When to Think About Changing Things Up
A portfolio re balancing can be done either on a set schedule or when the market conditions change. Re balancing one’s portfolio at set intervals, say every six or twelve months, is advised by many financial gurus. Having a calendar to remind you to think about re balancing is a great benefit of this strategy.
Some financial experts suggest re balancing if and only if the percentage of assets in a given category changes by more than a certain threshold. The benefit of this strategy is that you may learn when to re balance from your investments themselves. As a general rule, re balancing is most effective when it is performed infrequently.
Where to Look for Further Details
The SEC’s website features a helpful section under “Investor Information” where you can learn more about investing safely and avoiding blunders. Visit the FINRA’s Smart 401(k) Investing website and the Department of Labor’s Employee Benefits Security Administration website to learn more about many investment issues, such as asset allocation, diversification, and re balancing in the context of retirement savings.
Investment magazines, mutual fund firms, and other financial experts all have websites where you may take free online quizzes to learn more about your risk tolerance. In fact, based on your answers to their questionnaires, several of these services will make educated guesses about your asset allocations. However, investors should keep in mind that the results may be biased towards financial products or services sold by companies or individuals maintaining the websites, even though the suggested asset allocations may be a useful starting point for determining a suitable appropriation for a particular goal.
After you have begun investing, you can usually find useful information and tools online to assist you in keeping track of your holdings. Many mutual fund companies, for instance, allow investors to perform a “portfolio analysis” on their investments through the company’s website. Your asset allocation, the degree to which your investments are diversified, and the necessity of a re balance are all questions that can be answered by examining the results of a portfolio analysis.
