With thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. But if you don’t do it correctly you can undermine your ability to build wealth and a nest egg for retirement.
So instead of stock picking, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold. This is referred to as your asset allocation.
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, property and derivatives. Each asset class has different levels of risk and return, so each will behave differently over time.
For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a recipe for mediocre returns, but for most investors it’s the best protection against a major loss should things ever go amiss in one investment class.
The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the side-lines.
There is no simple formula that can find the right asset allocation for every individual, however, we have outlined five points that we feel are important when thinking about asset allocation:
- Risk vs. Return
The risk-return trade-off is at the core of what asset allocation is all about. It’s easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest “potential” (stocks and derivatives) isn’t the answer.
What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return.
Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you can’t keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities.
- Don’t Rely Solely on Financial Software
Financial-planning software investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one old rule of thumb that some advisors use to determine the proportion a person should allocate to stocks is to subtract the person’s age from 100. In other words, if you’re 35, you should put 65% of your money into stocks and the remaining 35% into bonds, property and cash.
However, these plans don’t consider other important information such as whether you are a parent, retiree or spouse. Financial institutions love to peg you into a standard plan not because it’s best for you, but because it’s easy for them. These can give you a rough guideline, but don’t get boxed into what they tell you.
- Determine Your Long- and Short-Term Goals
We all have our goals. Whether you aspire to build a large retirement fund, own a yacht or a holiday home, pay for your child’s education or simply save for a new car, you should consider it in your asset-allocation plan. All these goals need to be considered when determining the right mix.
For example, if you’re planning to own a holiday home on the beach in 20 years, 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 to six years, you may need to tilt your asset allocation to safer fixed-income investments.
- Time Is Your Best Friend
For every ten years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Start early.
Having time not only allows you to take advantage of compounding and the time value of money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A couple of bad years in the stock market will likely show up as nothing more than an insignificant blip 30 years from now.
- Just 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 breaks down.
It’s straightforward to see the percentage of assets in stocks versus bonds, but don’t forget to categorize what type of stocks you own (small, mid or large cap). You should also categorize your bonds according to their maturity (short, mid or long term).
Mutual funds can be more problematic. Fund names don’t always tell the entire story. You should dig deeper in the prospectus to figure out where fund assets are invested.
- The Bottom Line
There is no single solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don’t have, don’t worry. It’s never too late to get started.
It’s also never too late to give your existing portfolio a face-lift. Asset allocation is not a one-time event, it’s a life-long process of progression and fine-tuning.