Asset allocation is a risk-management strategy that divides assets into broad categories such as cash, bonds, stocks, real estate, and derivatives. Because each asset class has a different rate of return and risk, it will react differently over time. The goal is to align your asset allocation with your tolerance for risk and time horizon. Broadly speaking, the three main asset classes are:
- Stocks. Historically stocks have offered the highest rates of return. Stocks are generally considered riskier or aggressive assets.
- Bonds. Fixed income has historically provided lower rates of return than stocks. Bonds are typically considered safer or conservative assets.
- Cash and cash-like assets. While you don’t typically think of cash as an investment, cash equivalents like savings accounts, money market accounts, certificates of deposit (CDs), cash management accounts, treasury bills, and money market mutual funds are all ways that investors can enjoy potential upside with very low levels of risk.
1. Risk vs. Return
The risk-return tradeoff is at the heart of asset allocation. Everyone says they want the biggest possible return, but merely selecting the assets with the highest potential—stocks and derivatives—isn’t the solution.
2. Software and Planner Sheets
Financial planning software and survey sheets created by financial counselors or investment businesses might be useful, but never rely only on software or a predetermined plan. One old rule of thumb that some advisors use to determine the amount of a person’s portfolio that should be allocated to equities is to subtract the person’s age from 100. To put it another way, if you’re 35, you should invest 65% of your money in stocks and 35% in bonds, real estate, and cash.
Nevertheless, conventional worksheets may not often take into consideration other crucial facts, such as whether you are a parent, retiree, or spouse. Other times, these worksheets are based on a series of short questions that may not accurately reflect your financial objectives.
3. Set Your Goals
You should include it in your asset-allocation plan whether you want to establish a large retirement fund, acquire a yacht or vacation home, pay for your child’s education, or simply save for a new automobile. All of these objectives must be considered while establishing the best blend.
For example, if you plan to retire to a beachfront apartment in 20 years, you won’t have to worry about short-term stock market changes. If you have a child who will be entering college in five to six years, your asset allocation may need to be shifted to safer fixed-income investments. Also, as you near retirement, you may wish to transition to a bigger proportion of fixed-income investments to equity holdings.
According to the US Department of Labor, for every ten years you delay saving for retirement—or any other long-term goal—you must save three times as much each month to catch up.
Having time not only allows you to benefit from compounding and the time value of money, but it also allows you to allocate more of your portfolio to higher risk/return investments, such as equities. A handful of poor years in the stock market will most likely be remembered as a minor hiccup 30 years from now.
5. Stock Market Conditions
When the economy is doing well, it’s easy to imagine that the stock market will continue to climb indefinitely, which may drive you to pursue larger returns by owning more equities. This is a blunder. Because you can’t time the market and don’t know when a correction will occur, stick to a well-planned asset allocation strategy. If you allow market conditions to influence your allocation plan, you are not following a strategy.
6. Invest in a Target-date Fund
If reading about asset allocation has you drifting off, there is another option. You might put your money into a target-date fund, which will manage your asset allocation for you. A target-date fund is a mutual fund that invests in a variety of asset classes and gradually shifts to a more conservative asset allocation as the goal date approaches. The target date is mentioned in the fund’s name and represents the year you intend to retire. A 2055 fund, for example, is intended for people who want to retire in 2055.
Target-date funds generally adhere to best standards in allocation. They are diversified across and within asset classes, and the allocation considers your age. These monies are also simple to obtain. Apart for the cash in your emergency fund, you don’t need to actively manage your allocation or even hold any other assets.