In today’s complex financial markets, you have a seemingly infinite array of investment vehicles from which to select. Each investment also carries some risk, making it important to choose wisely if you are selecting just one. The good news is that there is no rule that says you must stick with only one type of investment. In fact, you can manage your investment risk and potentially increase your chances of meeting your investment goals by practicing “asset allocation.”1
Asset allocation refers to the way in which you combine different investments in your portfolio in order to try to meet a specific objective. For instance, if your goal is to pursue growth (and you are willing to take on market risk to do so), you may decide to place 20% of your assets in bonds and 80% in stocks.2
The asset classes you choose, and how you weight your investment in each, will probably depend on your investment time frame and how that matches with the risks and rewards of each asset class.
Stocks, Bonds and Cash Equivalents
Here is a closer look at the key risk and reward characteristics of the major asset classes:
Stocks–Well known for fluctuating frequently in value, stocks carry a high level of market risk (the risk that an investment’s value will decrease after it has been purchased) over the short term. Keep in mind, however, that stocks historically have earned higher returns than other asset classes, although past performance is no predictor of future results. Importantly, stocks also have a better track record of outpacing inflation–the rising prices of goods and services–than any other asset class, and therefore carry very low inflation risk.
Bonds–In general, these securities have less pronounced short-term price fluctuations than stocks, and therefore offer lower market risk. On the other hand, their overall inflation risk tends to be higher than that of stocks, as their long-term return potential is also lower. Bond returns may be influenced by movements in short-term interest rates. When interest rates rise, bond prices are likely to fall.
Cash equivalents–These assets are defined as being short-term, low-risk, low-return and highly liquid. Cash equivalents include U.S. government Treasury bills, bank savings accounts and bank certificates of deposit.3
Diversification: A Companion Strategy
Before exploring just how you can put an asset allocation strategy to work to help you meet your investment goals, you should first understand how diversification–the process of helping reduce risk by investing in several different types of individual funds or securities–works hand in hand with asset allocation.
When you diversify your investments among more than one security, you help reduce what is known as “single-security risk,” or the risk that your investment will fluctuate widely in value with the price of one holding. Diversifying increases the chance that, if and when the return of one investment is falling, the return of another in your portfolio may be rising (though there are no guarantees3). Neither asset allocation nor diversification guarantees against investment loss.
Asset Allocation: A Matter of Age and Objective
Although the ideal asset allocation will vary from person to person, standard investment wisdom states that the younger the investor, the more heavily a portfolio can be weighted toward stocks. As investors age, they may need to gradually shift to a more conservative asset allocation.
Chart illustrates hypothetical portfolio asset allocations: Aggressive Risk (younger investors); Moderate Risk (middle-aged investors); Low Risk (those nearing or in retirement). Allocations are presented only as examples and are not intended as investment advice. Please consult a financial advisor if you have any questions about how these examples apply to your situation.
A Simple Process, With Dramatic Potential
Once you have a carefully crafted asset allocation, maintain it. Review it on at least an annual basis, making alterations as your goals and other circumstances warrant. And rebalance the investment mix if the performance of one asset class throws it off kilter. Do this by adding new money to the asset class that is underrepresented in your portfolio or shift money from the overrepresented class to the others.
Regardless of the asset allocation strategy you choose and the investments you select, keep in mind that a well-crafted plan of action can help you weather all sorts of changing market conditions over the long term as you aim to meet your investment goal(s).
1Asset allocation does not assure a profit or protect against a loss.
2Investing in stocks involves risks, including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
3There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
4U.S. Treasury securities (“Treasuries”) are issued by the federal government and are considered to be among the safest investments you can make, because all Treasury securities are backed by the “full faith and credit” of the U.S. government. Certificates of deposit are FDIC insured and offer a fixed rate of return if held to maturity.
This article was prepared by Wealth Management Systems Inc. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions.
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