Not all investments are created equal. That’s why asset allocation is so important. Think of your portfolio as a pyramid and each dollar as a brick, spread out across…
…A solid foundation of savings, CDs and Treasury bills
…A conservative insulation of balanced funds, corporate and municipal bonds, and U.S. government notes and bonds
…A growth-oriented layer of stocks, mutual funds and investment real estate
…Topped with something speculative like fine art, coins, precious metals, commodities and venture capital
Asset allocation doesn't guarantee profits or safeguard you against loss. It’s simply an effective way of managing the level and type of risk you’re willing to face to achieve the returns you’re after.
Why allocate if it’s a gamble anyway?
Different assets carry different risks and potential. They don’t respond to market forces in the same way, or even at the same time. One asset type might be on the decline while the return on another could be exponential. The point is, by allocating across a range of investments, the downturn of a single holding won’t destroy your entire portfolio.
Assets Come in Three Sizes
Well, types. Here’s a look at what they are and how to use them:
Stocks: these generally perform at a higher average annual rate of return than other investments. But they’re volatile. If your investment goals are long-term and you’re willing to take on the risk, these can offer the most bang for your buck.
Bonds: these are more stable, but subject to interest rate changes. When rates are on the rise, bond values tend to fall, and when interest rates fall, bond values rise. Another difference is that bonds pay fixed interest payments at regular intervals, hence can provide income on investments. And most bonds have some level of certainty that you’ll receive your principal back when the bond matures – government bonds especially. This is why they’re considered safer, though not foolproof.
Cash alternatives: also known as short-term instruments, these are the least volatile type of assets. Of course, they also offer the lowest potential for growth. And they’re subject to inflation risk. What they do provide, however, is easy accessibility to funds when you need them.
You can diversify across these asset classes or diversify within a single asset class. Regardless of your investment style, your objective is to choose complementary investments that balance risk and reward.
Building a Diverse Portfolio
Most investors rely on mutual funds to build portfolios that match their asset allocation strategies. Mutual funds offer:
- Instant diversification with the added benefit of professional money management—for actively managed funds at least.
- Investment tactics geared for specific objectives, such as: capital preservation; income; moderate growth and aggressive growth.
Note: Before investing in a mutual fund, carefully consider its investment objectives, risks, fees and expenses, which can be found in the prospectus.
You could sit back and watch your money ebb and flow; however, the wise thing to do would be to revisit your portfolio at least once a year. First of all, it’s your money. Take an active role in it! Secondly, sometimes you’ll need to rebalance your portfolio, especially during market fluctuations. That doesn’t mean you should make radical shifts. You’re in it for the long haul, after all. But as your financial goals evolve and change…your tolerance for risk will change, too. When it does, it’s time to re-allocate.