With thousands of stocks, bonds and mutual funds to choose from, choosing the right investments can confuse even the most seasoned investor. But if you don’t do it right, you can undermine your own ability to build wealth and a retirement nest egg. So what’s the best thing to do? Instead of choosing stocks, you should start by deciding what combination of stocks, bonds and mutual funds you want to own. This is called your asset allocation. In this article, we take a look at asset allocation and five of the most important things you need to know about this technique.
Key points to remember
- Asset allocation attempts to balance risk by allocating assets among investment vehicles.
- The risk-return trade-off is at the heart of asset allocation.
- Don’t rely entirely on financial planning software and survey sheets.
- Know your goals.
- Time lets you take advantage of compounding and the time value of money.
What is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk by dividing assets between major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time.
For example, while one asset class increases in value, another may or may not increase as much. Some critics see this balance as a recipe for mediocre returns, but for most investors it’s the best protection against a big loss if things ever go wrong in an investment class or subclass.
The consensus among most finance professionals is that asset allocation is one of the most important decisions investors make. In other words, your selection of stocks or bonds is secondary to how you allocate your assets to high and low risk stocks, short and long term bonds and cash.
Most finance professionals believe that asset allocation is one of the most important decisions investors can make.
There is no simple formula for finding the right asset allocation for each individual. If there was, we certainly wouldn’t be able to explain it in a single article. However, we can highlight five points that we believe are important when thinking about asset allocation.
1. Risk versus return
The risk-return trade-off is at the heart of asset allocation. It’s easy for anyone to say they want the highest return possible, but simply picking the assets with the greatest potential — equities and derivatives — isn’t the answer.
The crashes of 1929, 1981, 1987 and the more recent declines following the global financial crisis between 2007 and 2009 are all examples of times when investing only in stocks with the highest potential return was not the plan. most prudent action. It’s time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. .
Yes, investors with higher risk tolerance should allocate more money to stocks. But if you can’t stay invested during the short-term swings of a bear market, you should reduce your equity exposure.
2. Software and planning sheets
Financial planning software and survey sheets designed by financial advisers or investment firms can be beneficial, but never rely solely on software or a pre-determined plan. For example, an old rule of thumb that some advisers use to determine how much a person should allocate to stocks is to subtract the person’s age from 100. In other words, if you are 35, you should invest 65% of your money in stocks and the remaining 35% in bonds, real estate and cash. More recent tips have changed to 110 or even 120 minus your age.
But standard worksheets sometimes don’t take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that don’t consider your financial goals.
Remember, financial institutions love to put you on a standard plan not because it’s best for you, but because it’s easy for them. Rules of thumb and planner sheets can give people a rough guideline, but don’t get locked into what they tell you.
3. Know your goals
We all have goals. Whether you aspire to build a large retirement fund, own a yacht or a vacation home, pay for your child’s education, or simply save for a new car, you should factor this into your asset allocation plan. All of these goals should be considered when determining the right combination.
For example, if you plan to own a retirement condo on the beach 20 years from now, you don’t have to worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five or six years, you may need to shift your asset allocation toward safer fixed income investments. And as you approach retirement, you may want to shift to a higher proportion of fixed income investments in favor of equities.
4. Time is your best friend
The US Department of Labor says that every 10 years you put off saving for retirement — or another long-term goal — you need to save three times as much each month to catch up.Inasmuch asInasmuch as
Having time not only allows you to benefit from compounding and the time value of money, but it also means that you can invest more of your portfolio in higher risk/reward investments, namely shares. A few bad years in the stock market will likely appear as nothing more than an insignificant hit 30 years from now.
5. Do it!
Once you’ve determined the right mix of stocks, bonds, and other investments, it’s time to implement it. The first step is to find out how your current portfolio is breaking down.
It’s pretty straightforward to see the percentage of assets in stocks versus bonds, but don’t forget to categorize the type of stocks you own: small, mid, or large cap. You should also classify your bonds according to their maturity, short, medium or long term.
Mutual funds can be more problematic. Fund names don’t always tell the whole story. You have to dig deeper into the prospectus to find out where the fund’s assets are invested.
There is no one-size-fits-all solution to allocating your assets. Individual investors need individual solutions. Also, if a long-term horizon is something you don’t have, don’t worry. It’s never too late to start. It’s also never too late to spruce up your existing portfolio. Asset allocation is not a one-time event, it is a lifelong process of progression and adjustment.