Asset allocation depends mostly on your time horizon and the ability to take risks.
With thousands of bonds, stocks, and mutual funds to choose from, picking the right investment vehicle can confuse and complicate the plans of even the most seasoned investor. But when done incorrectly, investors can undermine their ability to build wealth. So, what’s the right approach? Stop stock picking and instead start by deciding what mix of investments you want to hold, which is referred to as asset allocation.
The agreement among financial professionals is that asset allocation is one of the critical decisions investors make. In other words, the selection of stocks or bonds comes secondary while allocating your assets to high and low-risk stocks, to short and long-term bonds, and to cash.
Let’s take a look at asset allocation, and outline five of the important things you need to know about asset allocation.
Is Risk Vs. Return Crucial?
The risk-return trade-off is the pendulum of what asset allocation is all about.
It’s easy to say that you want the highest possible return, but simply opting for assets with the highest potential, stocks and derivatives, isn’t the answer.
The decline following the global financial crisis between 2007 to 2009 is an indication of times when investing in only stocks with the highest potential return was not considered the most prudent plan of action. It’s time to accept the facts; successful investors are the ones who have the ability to weigh the relationship between risk and return.
Investors with a higher risk tolerance should allocate more funds into stocks. On the other hand, if you can’t remain invested through the short-term fluctuations of a bear market, cut down your exposure to equities.
Is Technology A Safe Bet?
Technology is ruling the world and it’s no surprise that advanced tools are available for pre-determining a plan for investments in the form of financial planning software and survey sheets designed by investment firms or financial advisors.
For example, some financial advisors determine the proportion a person should allocate to stocks which is to subtract the person’s age from 100.
|If you’re 35 yrs||Put 65% of your money into stocks + remaining 35% into bonds, real estate, and cash|
But relying solely on standard worksheets alone might not be a great idea as they don’t take into account vital information such as whether you are a retiree, parent, or spouse. Otherwise, these worksheets are based on a set of simple questions that fail to capture your financial goals.
Remember, planner sheets can give people a rough and superficial guideline, but falter by not ticking the right boxes.
What Are Your Goals?
We all have financial goals, and to achieve those, preference should be given in your asset-allocation plan. All these goals need to be prioritised when determining the right mix.
The common reason for changing your asset allocation is a change in your time horizon. In other words, as you approach your investment goal, improving your asset allocation becomes necessary and hence a shift to a higher proportion of fixed-income investments to equity holdings.
Generally, people investing for retirement hold less stock and cash equivalents and more bonds during their retirement age. A change in your financial situation, risk tolerance, or the financial goal itself might require to alter your asset allocation.
What is Your Best Asset?
Having time is an added advantage for compounding and the time value of money. Still, it also means adding more of your portfolio into higher risk/return investments, namely stocks. A couple of bad years in the market will likely show up as nothing more than an insignificant blip 30 years from now.
For every 10 years, a delay in saving for retirement (or some other long-term goal) you have to save thrice as much each month to catch up.
Should You Go For It?
After locking the right mix of bonds, stocks, and other alternative investments, it’s time to implement it. The primary step is to figure out how your current portfolio breaks down.
It’s fairly straightforward to see the percentage of assets in stocks versus bonds, but don’t forget to categorise:
- what type of stocks you own – small, mid, or large-cap
- your bonds according to their maturity – short, mid or long-term
To be successful investors need not track market changes daily, but being aware of the trends in the marketplace can cut down on listening to unwanted or irrelevant rumour mills throughout the day. An excellent way to keep yourself motivated and focused is to chase the right kind of information.
Investments are both short term and long term and hence stop worrying about short-term fluctuations in the market. Fund names don’t always reveal the entire story, and that’s why you have to dig deeper in the prospectus to identify where fund assets are invested. Remember, while one asset category increases in value, another may decrease or may not increase as much. Some critics see this balance as a formula for mediocre returns, but for investors, it’s the best protection against a significant loss should things ever go amiss in one investment class or sub-class.