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Asset allocation is a crucial part of investing because it is a major influence on how your portfolio behaves and on the kind of returns you can expect. It dictates what portion of your assets is exposed to high risks, and what portion can yield potentially high returns or stable low returns.
When you understand asset allocation strategies, you can balance your portfolio in view of your financial goals and achieve these goals. You can design a strategy to keep your exposure to risks at a level you are comfortable with and to keep growing your investment portfolio quickly enough to allow you to retire as planned.
There isn’t a single good way to allocate assets since the ideal strategy depends on your attitude towards risks and returns. You will also have to make a few changes to your asset allocation strategy as your goals change or as you approach retirement.
The only place where success comes before work is in the dictionary.
– Vidal Sassoon
An asset class refers to a group of investment vehicles that can be used to achieve similar financial goals. These investment vehicles are usually regulated in a similar manner. You can expect comparable returns and risks within the same asset class.
Asset class is an important concept, since it helps you gain exposure to different types of investment vehicles. Diversification exists across asset classes but you can also diversify your investments within the same class.
Investment vehicles can be organized into four main classes. It’s important to understand what each class can do for your portfolio, so you can decide on the best asset allocation strategy possible.
Cash equivalents are the safest way to invest your money. The downside is that returns are fairly low compared to other asset classes.
There are some advantages to investing in cash equivalents in spite of the low returns:
1. Cash equivalents don’t lose their value if the market takes a turn for the worse.
They should represent a significant portion of your portfolio if you’re a conservative investor.
2. You can invest in cash equivalents on the short-term.
This asset class is ideal if you’re approaching retirement.
3. Some cash equivalent products can be borrowed against.
This is a good investment if you believe you’ll need to borrow against your portfolio in the future, for instance, to finance a house.
4. Returns are usually set in advance.
You know exactly what your investment will yield, what the maturity date is, and will not be tempted to take additional risks to potentially earn more.
5. Cash equivalents are very liquid. Some products that belong to this asset class give you access to your money at any time.
Savings accounts are a popular investment vehicle that belongs to this asset class. Money market instruments also belong to this class, including certificates of deposits, repurchase agreements, federal funds and U.S. Treasury bills, and commercial papers.
Cash equivalents are best used to keep your money safe and secure, with guaranteed profits, even if the returns are low compared to other investments.
Cash equivalents will not help you grow your portfolio to any great extent, but allocating a percentage of your resources to this type of safe investments will protect you from losses in case other portions of your portfolio don’t perform well.
Fixed income securities are investment vehicles with regular payments. You also get your initial investment back once the product reaches its maturity.
There are a few downsides to investing in fixed income securities:
1. These securities are traded between dealers and between dealers and individual investors.
There is no central pricing information, which can make it difficult to know if you’re paying a fair price.
2. Some securities are very difficult to find.
It could be months before you have the opportunity of purchasing the security you were interested in.
3. The returns are low.
On the plus side, you aren’t taking any significant risks. Plus, you benefit from a predictable income.
Fixed income securities are a great way to protect your portfolio from market fluctuations. You will receive the scheduled payouts regardless of how the market performs and can actually generate a nice profit with this type of securities if you wait for the right products to be available.
Bonds are the most popular fixed income securities. You can purchase bonds from the U.S. government or from foreign governments, but should also consider investing in corporate bonds. This asset class also includes preferred stocks with dividends.
This asset class is a fairly safe way to invest your money. Some securities carry higher risks than others do, but you can easily avoid taking risks by investing in bonds issued by governments and large corporations.
Bonds and other fixed income securities do not require you to actively manage your portfolio and provide you with a reliable source of income. The returns are fairly low, but these investment vehicles are still a good way to build your portfolio and receive a regular income.
Equities are an asset class that covers shares of companies traded on the stock market. Technically, investing in equities means you are purchasing portions of companies.
This asset class carries higher risks since the value of a company share greatly depends on how the company is performing at the time you buy. However, from a historical point of view, returns have been higher on this market compared to bonds and cash equivalents.
Equities are the asset class that will make your portfolio grow. On the other hand, the higher risks mean you can lose large amounts of money if a company underperforms or if an entire sector of the market is in bad shape.
Follow these simple rules to make wise decisions when investing in equities:
1. Equities perform well when the economy is in good shape and when inflation is low.
If the inverse is true, focus on other asset classes for a while.
2. Create a diversified equity portfolio.
Invest in multiple companies and in various sectors. Diversifying your investments will lower the risks associated with equities, but will not be enough if the economy as a whole is in bad shape.
3. Do your research.
Always look at historical data and do research on the company you want to invest in before buying shares.
Stocks are a popular option, but consider these investment products from this asset class as well:
Investing in these funds usually carries lower risks than purchasing individual shares.
It’s possible to save for retirement with a portfolio that includes these three asset classes, without ever holding any physical investments. However, investing in a physical asset is a good way to create diversification outside of the financial institution you trust with your portfolio.
Real estate is by far the most popular type of investment in this asset class. With real estate, you can get growth from the appreciation of your properties and regular income from renting out your properties.
There are some disadvantages to investing in real estate, including high maintenance fees, the possibility of a property losing its value, and the fact that being a landlord is a lot of work.
Precious metals are another popular physical asset. You can build a collection of coins and bullion over the years and even deposit qualifying coins and bullion into an IRA if you no longer want to store them in your home.
Other investors see art, classic cars, and other collectibles as good ways to save for retirement. Even though these markets are unpredictable, you can definitely make a profit from these investments as long as you’re an expert on the kind of items you invest in.
It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.
– Robert Kiyosaki
Your goal as an investor is to make your money work for you.
However, it’s important for your own peace of mind to assess your risk tolerance and determine what kind of profits you’re looking for before you decide on an asset allocation strategy.
Risk and reward usually go hand in hand. Investing vehicles, like stocks, allow for high potential returns, but also carry higher risks. Products such as certificates of deposits and savings accounts are at the low end of the risk spectrum, but do not allow for large profits.
Diversification across asset classes and within asset classes needs to reflect your attitude towards risks.
As you approach retirement, losing a large portion of your portfolio would be a disaster you might not recover from. So it’s smart to gradually allocate a larger portion of your portfolio to safe investments you can rely on for regular payouts. A smaller portion should be dedicated to equities to still gain exposure to potentially high returns without risking too much.
If you are still years away from retirement and have a small portfolio as well as a regular source of income, taking risks is a good strategy. You will have years to recover from a loss and grow your portfolio.
Allocate your assets to different classes within these ranges in view of how aggressive or conservative your approach to investing is:
Equities should account for anywhere between 50% and 90% of your portfolio. Some experts recommend following this formula: Take 110 and deduct your age from this number to get an idea of the percentage of stocks that might work well for you.
2. Cash equivalents.
Allocate 20% of your portfolio to cash equivalents if you adopt a conservative approach. If you’re looking for quick growth, this asset class can be missing from your portfolio.
3. Fixed income securities.
Allocate 40 to 60% of your portfolio to fixed income securities if you will rely on that income during the next few years. If you’re focused on aggressive growth, fixed income securities might account for as little as 10%.
I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy.
– Warren Buffett
Stocks can make your portfolio grow, but allocating 90% of your portfolio to a single market is a terrible mistake. Diversification is crucial when investing in equities. It’s also important to pick stocks or funds that will likely perform well.
Investing in large, well-known companies is a tempting option due to the many unknown factors that come into play when buying shares of smaller businesses. However, historical data reveals that the higher returns usually come from small companies that become successful.
The best approach is to create a mix of safer stocks from large companies that will still be around when you retire and stocks from promising small companies.
There are two ways to justify purchasing shares of a company. Try to include a mix of stocks that fall into these two categories:
1. Growth stocks.
These stocks have a good potential for high returns. Think tech startups and other emerging markets.
2. Value stocks.
These stocks are a good addition to your portfolio because they are likely to retain their value, you feel that you get a good price, and are comfortable with investing in this company. This category includes major chains and most stocks with dividends.
A company’s size and value is another thing to look at when picking stocks. Ideally, include a mix of shares from companies that fall into these categories:
1. Large cap.
This category includes huge retailers such as Walmart or Amazon.
2. Mid cap.
These well known companies usually dominate their market. Your local energy provider is more than likely a mid cap company.
3. Small cap.
These companies still have potential for growth. Most holding companies belong to this category.
4. Micro cap.
This category includes small businesses and startups.
The smaller the company, the higher the risk usually is. But from a historical point of view, small companies yield the highest profits. On the other hand, investing in large cap companies is a safer approach but yields lower returns. This is why diversifying with a mix of growth and value stocks as well as a mix of cap sizes can help you make the most of your portfolio.
Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.
– Dave Ramsey
Passive investors tend to look for safer investments and to follow trends, while active investors take the time to pick individual stocks to achieve the highest return possible. Adopting an active approach to investing carries higher risks, but can lead to higher profits.
Your asset allocation strategies depend on your attitude towards active and passive investing. Fixed income securities and cash equivalents should account for a large portion of your portfolio if you decide to adopt a more passive approach. Select index funds and other similar investment vehicles to add some equity to your portfolio instead of picking stocks.
Using a mix of both approaches is a smart strategy. If you don’t like much risk, you could dedicate a percentage of your portfolio to passive investing techniques and use a smaller percentage to invest more actively.
The Stock Market is designed to transfer money from the Active to the Patient.
– Warren Buffett
Your portfolio has to meet certain financial goals so you can retire on time and live comfortably. Your ideal retirement age should be taken into account when deciding on an asset allocation strategy. If you fail to properly balance your portfolio, you might have to work longer or might not live as comfortably as you wish once you retire.
If you’re decades away from retirement, focusing on stocks is the best way to grow your portfolio. Start choosing safer investing vehicles as you approach retirement to build a solid basis of fixed income securities that will provide you with a guaranteed income.
As you go through different stages of life, you’ll also notice that the economy goes through cycles. Some of these cycles will be positive ones where the economy is growing and where you can find lucrative stocks to invest in. You’ll also find that it is best to focus on safer investment vehicles when the entire economy is not performing well.
The individual investor should act consistently as an investor and not as a speculator.
– Ben Graham
You cannot pick an asset allocation strategy and follow it throughout your entire life. Your portfolio needs to be rebalanced on a regular basis. For example, you may want to reshape your portfolio once you retire and begin withdrawing returns from your fixed income securities.
These different events call for a rebalancing of your portfolio:
1. You consistently fail to meet the financial goals you set for your portfolio.
This is a sign that you might need to switch to a more conservative approach, set reasonable goals, and perhaps get help from a professional.
2. The stock market crashes.
Your best option is to focus on safer investments until the economy picks up again, or take advantage of low prices to purchase shares of companies that are likely to recover.
3. A major life event affects your finances.
Having a baby or losing your job means you might no longer be able to contribute a certain percentage of your income to your portfolio. Avoid taking risks, since you might not recover from a large loss if you can no longer make regular contributions.
Go over your financial goals regularly to ensure your current asset allocation strategy is still relevant. Re-evaluate your strategy in view of how the market is performing and re- balance your portfolio little by little as investment vehicles reach maturity and provide you with funds to reinvest.
If plan A fails, remember there are 25 more letters.
There isn’t a single best way to grow and manage your portfolio. It helps to know about asset allocation and understand what each class of assets can do for you.
Choose your asset allocation strategy based your goals, the risks you are comfortable with, and how the market is performing. Think about getting help from a professional if you are not sure how to balance your portfolio or want recommendations for specific investment vehicles.
Wealth is not his that has it, but his that enjoys it.
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