If you’re like most people, you are interested in learning more about investing because you have financial goals that you hope to reach. Whether you are saving to buy your family’s forever home, building a college fund for your kids, or you’re laser-focused on retirement, having an investment plan in place that prioritizes asset allocation can potentially improve your chances of long-term success.
Asset allocation is one of the most fundamental principles of sound investing, so if you are new to investing you will want to take the time to understand what it means, why it’s important, and how you can work towards the right mix of asset allocation in your investment portfolio.
What Is Asset Allocation?
No matter how prudent of an investor you are, the truth is that investing is riskier than socking your money away in a savings account. However, savvy investors implement strategies in seeking to help reduce risk and pursue a greater return than the tiny interest rate you can expect by letting your money sit in the bank. Asset allocation is one such investment strategy.
The goal of asset allocation is to balance risk and reward based on your individual financial resources, circumstances, and goals. It involves taking a close look at where you stand and what you want to pursue and then dividing your investment portfolio accordingly among a diverse range of asset classes or categories.
Each asset class is expected to behave differently over time in terms of the level of risk and return, so the ideal mix to choose will depend on your risk tolerance, time horizon, and specific goals.
Types of investment assets include real estate, private equity, precious metals, commodities, cash, stocks, and bonds, but the three main asset categories to take into consideration first are equities, fixed-income securities, and cash or equivalents.
Equities
Equities, as an asset class, refers to shareholder equity, or the value an asset such as a share in a company, would return if it were to be liquidated and sold off. In your investment portfolio, equities are typically stocks or other securities representing an ownership interest.
Among the major asset categories, historically, stocks have the greatest risk and the highest returns. They tend to be a risky investment in the short term, but if you are willing and able to ride out the volatility of the stock market over the long-term, you may be more likely to be rewarded with strong returns.
Fixed-Income Securities
The fixed-income asset class refers to investments that provide returns in fixed interest payments, periodically, with the return of your principal upon maturity. You go into a fixed-income investment knowing it will provide steady interest income over a period of years.
The most common type of fixed-income investment is a bond, which is issued by the government or a corporation to raise funds to finance projects. The face value of a bond is the amount you will receive when that bond matures. The price is not guaranteed but, historically, bonds are less volatile than equities and can help potentially lower risk in an investment portfolio.
Cash and Cash Equivalents
Cash or cash equivalents are the asset class that includes savings deposits, certificates of deposit, money market funds and deposit accounts, and treasury bills.
Out of the main asset categories, cash and cash equivalents offer low risk and low rate of return. Because these investments are low risk, you are not likely to lose your money directly. However, you may lose money if inflation outpaces your returns over time.
There isn’t a one-size-fits-all formula for effective asset allocation as everyone’s personal situation differs. The best asset allocation for your portfolio will depend on your individual circumstances at any given time.
Why is Asset Allocation Important?
Asset allocation is one of the most important steps for any investor. In fact, many financial professionals agree that the way the assets in your portfolio are allocated is equally, if not more, important to your overall investment success than the individual securities in your portfolio.
The reason asset allocation is so important is that the different asset categories perform differently under a wide range of possible market conditions. Historically, the market has shown that returns in the major categories — fixed-income, equities, cash and equivalents — have not moved up and down at the same time, across the board. As one category provides poor returns, another asset category will tend to do well.
When market conditions cause one category to go down, another one is up, so spreading the risk by diversifying can counteract individual investment failures and help protect against significant losses overall.
While the purpose of asset allocation is to reduce risk, it’s also important to keep in mind that your goal should be to do so without sacrificing too much potential gain. You will need to allow enough risk in your portfolio to pursue a return on your investments so you can meet your financial goals.
If your goals are short-term, such as wanting to buy a new car next year, you’ll want to allocate for less risk so the money is there when you need it. For longer-term goals, such as retirement, you may have time for more risk.
How to Pursue Appropriate Asset Allocation
To pursue appropriate asset allocation in your investment portfolio, you’ll need to select a mix of assets suitable for pursuing your goals at a level of risk you can tolerate. But the mix isn’t something you just set and forget; it isn’t fixed. Most likely, you will need to adjust your mix of assets as time goes on, circumstances change, and you get closer to your goal mark.
Your appropriate asset allocation depends largely on your time horizon and risk tolerance.
Time Horizon
Your time horizon refers to the expected time countdown in terms of decades, years, or months that you plan to invest in hopes of reaching a particular financial goal.
If you have a short time horizon to reach a goal, such as saving for your teenage child’s college fund, it would be best to take on less risk in the asset allocation of your portfolio. If you have a longer time horizon, such as retirement in 30 years, you have time to ride out the inevitable ups and downs of volatile markets and can allow for more risk in your asset allocation.
Risk Tolerance
Your risk tolerance refers to your level of willingness to take a loss on the money you invest in exchange for a greater potential return. Having a low-risk tolerance means you are a conservative investor and you need or want to focus on preserving as much of your original investment as possible. If you have a high-risk tolerance, that means you are considered an aggressive investor, and you’re more open to losing money in hopes of a higher return.
If you have a low risk tolerance because your time horizon is short or your resources are limited, your appropriate asset allocation will be weighted more conservatively. If you have a high risk tolerance because your time horizon is long or you have a comfortable amount of assets saved, your appropriate asset allocation can be more heavily weighted toward aggressive investments.
Conclusion
Determining your appropriate asset allocation to work towards your financial goals is a complex task and not one to be taken lightly. Working with a financial advisor can help you make decisions that align with your financial goals and manage your asset allocation effectively over time.
Kevin Stoddard is a LPL Financial Advisor with Stoddard Financial in Quincy, Massachusetts. Stoddard helps clients throughout New England to identify, plan, and execute strategies designed for securing their desired financial future. With their Financial Wellness @ Work program, they engage, educate, and empower employees by helping them to understand and appreciate the value of their benefits package.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not protect against market risk.
The fast price swings in commodities will result in significant volatility in an investor’s holdings.
CDs are FDIC Insured to specific limits and offer a fixed rate of return if held to maturity.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate, and is intended merely for educational purposes, not as advice.