Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices. But since guessing which asset category will do best at a certain time is very difficult, it can make sense to divide your investments among asset categories. Understanding this strategy can be key to investment success.
Asset allocation means diversifying your money among different types of investment categories, such as stocks, bonds and cash. The goal is to help reduce risk and enhance returns.
This strategy can work because different categories behave differently, Stocks, for instance, offer potential for both growth and income, while bonds typically offer stability and income. The benefits of different asset categories can be combined into a portfolio with a level of risk you find acceptable.
Establishing a well-diversified portfolio may allow you to avoid the risks associated with putting all your eggs in one basket.
Asset allocation decisions involve tradeoffs among 3 important variables:
Depending on your age, lifestyle and family commitments, your financial goals will vary. You need to define your investment objectives—buying a house, financing a wedding, paying for your children's education or retirement. Besides defining your objectives, you also need to consider the amount of risk you can tolerate.
For example, when you retire and are no longer receiving a paycheck, you might want to emphasize bonds and cash for income and stability. On the other hand, if you won't need your money for 25 years and are comfortable with the ups and downs of the stock market, a financial advisor might recommend an asset allocation of 100% stocks.
Here are examples of 3 model portfolios that can give you a sense of how to approach selecting your own asset mix. Remember, these are general suggestions only. When reviewing the sample portfolios, consider your risk tolerance and your other assets, income and investments.
This portfolio emphasizes growth, suggesting 65% in stocks or equity funds, 25% in bonds of fixed-income funds and 10% in short-term money market funds or cash equivalents. Investment experts recommend this portfolio for people who have a long investment time frame. The portfolio provides for short-term emergencies and a mid-term goal such as building a home, but otherwise assumes the investor has long-term goals such as retirement in mind.
The portfolio seeks to balance growth and stability. It recommends 50% in stocks or equity funds, 30% in bonds or fixed-income funds and 20% in short-term money market funds or cash equivalents. This portfolio would seek to provide regular income with moderate protection against inflation. The equity component provides the potential for growth, whereas the component in bonds and short-term instruments helps balance out fluctuations in the stock market.
This portfolio suggests 25% in stocks or equity funds, 50% in bonds or fixed-income funds, and 25% in money market funds or cash equivalents. This portfolio appeals to people who are very risk averse or who are retired. The 25% equity component is intended to help investors stay ahead of inflation.
While an asset allocation plan eliminates a lot of the day-to-day decisions involved in investing, it doesn't mean you should just "set it and forget it." Reviewing your portfolio regularly with your financial advisor to monitor and rebalance your asset allocation can help make sure you stay on track to meet your goals.
No matter what type of savings programme you choose, it's important to review your portfolio every 6-12 months to assess your progress. Your financial advisor can provide you with expert help in determining the best way to allocate your assets.