One of the best ways for ordinary Americans to build long-term wealth is to invest in stocks.
Investing in stocks comes with several risks that might not make it the best idea to keep all of your money invested in them for your entire life. Even the greatest stock investor of our time, Warren Buffett, doesn’t invest all his money in stocks.
That’s where asset allocation comes into play. The investment strategy is looking to have a mix of safe and less safe investments to balance out the risk and potential rewards. This way, if some investments do poorly, others may make up for those losses.
The following guide will help investors understand the importance of asset allocation and the most crucial factors in determining the best mix of assets.
The asset allocation of a portfolio is the strategy that divides the investment among different asset classes. This process creates a mix of assets that offsets riskier assets with less risky ones.
Since asset allocation is largely based on an investor’s risk tolerance and investment time horizon, it is often a very personal decision.
The primary driver of the volatility an investor encounters and the returns they earn is asset allocation. A study from Vanguard suggests that having a diversified portfolio is more important than the individual stocks within that portfolio, with 88% of an investor’s experience being tied to asset allocation.
This means that investors who had the same investments generally had the same experiences. The reason for this is mostly because assets in the same category tend to move in the same direction.
Asset allocation is important, so investors need to find a mix that works for them in terms of risk tolerance and investment time horizon.
Two hypothetical investors are being looked at as an example. One is single, 25 years old, with no kids and a stable career. The other is a married 65-year-old who recently retired.
The first investor’s time horizon for investing is much longer than the second investor’s because the first investor is still several decades away from retirement, while the second investor is already retired.
The first hypothetical investor can afford to take more investment risks because they don’t have a family yet, but the second will likely want to play it safe.
Thus, their asset allocations will likely be quite different. The first investor can afford to keep a larger portion of their portfolio in riskier assets because they can afford to lose some money without it having a large impact on their life.
If you are close to retirement, you may want to put more of your money into less risky investments. This is because you will not have as much time to make up for any losses if your investments do not do well.
Types of Assets
There are three primary investment asset classes:
Investing in equities, or stocks, gives the investor an ownership stake in the company. Equity investments are those that involve ownership in a company, including common stock, preferred stock, mutual funds, and exchange-traded funds (ETFs).
The equity investments might pay dividends or not, depending on the type of investment. Growth stocks, for example, don’t usually pay dividends.
2. Fixed Income
Fixed-income investments are debt securities issued by a company or government entity, or a loan made to an individual.
There are three types of fixed-income investments: corporate bonds, municipal bonds, and Treasury bonds. Other types of loans with fixed-rate income payments include mortgage loans, bridge loans, and personal loans.
3. Cash and Equivalents
Cash and equivalents refers to cash, savings accounts, money market accounts, and bank CDs.
“]There are several other types of investable assets in addition to the three main asset classes. This includes investment in real estate (such as rental properties, farmland, and commercial real estate), commodities (like gold), futures contracts, and other financial derivatives (such as options), as well as cryptocurrencies.
Asset Allocation 101
Diversifying your portfolio is a good way to reduce your risk of losing all your money or having your investment value go up and down a lot.
By asset allocation, we not only diversify our portfolio but also introduce less risky assets like fixed income. For example, here’s how increasing an investor’s allocation to fixed income can impact their portfolio’s overall volatility and returns:
The table below indicates that, on average, a portfolio consisting entirely of stocks outperformed portfolios that included some fixed-income investments.
It also produced the best overall year. This hypothetical portfolio also had the most years with losses and the biggest one-year loss.
As investors increased their investment in bonds, they saw a decrease in their overall annualized return. Although they increased investment, they also reduced risk, as shown by the lower loss in the worst year and the fewer years with losses.
A more balanced portfolio generated some higher one-year returns compared to a bond allocation. portfolios with a less than 100% bond allocation had more years of losses than more balanced portfolios.
Adding more asset classes to a portfolio can help stabilize returns and improve profits. A portfolio that is 60% stocks and 40% bonds has, on average, produced an 8.15% return annually over the past 30 years.
This portfolio has a higher risk than average, with an annualized volatility of 10.68% and a Sharpe ratio of 0.76.
A portfolio with a 10% allocation to real estate and farmland outperformed a portfolio with 48% stock and 32% fixed-income allocations in terms of total return, volatility, and risk.
The time horizon you are willing to invest for will determine how much risk you are willing to take on to achieve a certain goal.
An investor who can wait out slow economic cycles and the inevitable ups and downs of our markets may feel more comfortable taking on a riskier investment.
An investor with a longer time horizon can afford to take on more risk because they have time to make up for any losses.
Your risk tolerance is what determines how much of your original investment you are willing to lose in order to get greater potential returns. An investor who is willing to take on more risk is more likely to see greater losses in order to achieve better results.
An investor who is conservative, or who has a low tolerance for risk, is more likely to invest in something that will protect their original investment. This is referring to the differences in attitude between conservative and aggressive investors.
Conservative investors want to hold on to what they have and are less likely to take risks, while aggressive investors are more likely to take risks in hopes of getting a higher return.
Risk Versus Reward
There is a close relationship between risk and reward when it comes to investing. The phrase “no pain, no gain” means that you have to work hard and be willing to sacrifice in order to achieve something. This is similar to the relationship between risk and reward, where you have to take risks in order to get rewards.
Don’t let anyone tell you otherwise. All investments involve some degree of risk. If you’re thinking about buying stocks, bonds, or mutual funds, be aware that you could lose part or all of your investment.
The potential for a greater return on investment is the reward for taking on risk.
If you have a financial goal that will take a long time to achieve, you are more likely to make more money by investing in asset categories that are more risky, like stocks or bonds, rather than only investing in assets that are less risky, like cash equivalents.
If your short-term financial goals don’t include earning a higher return, investing only in cash investments may be a good option.
Treasury securities The SEC cannot recommend any particular investment product, but there is a huge range of investment products available, including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. Treasury securities.
An investment portfolio that includes stocks, bonds and cash can be a good way to achieve a variety of financial goals. Now that we have looked at the different types of assets, let’s focus on the main features of each category.
Stocks are generally seen as the asset class with the most risk but also the highest returns. Stocks are the asset category that offer the greatest potential for growth in a portfolio.
Stocks hit home runs, but also strike out. The short-term riskiness of stocks makes them a not-so-great investment. On average, large company stocks have lost money one out of every three years.
And sometimes the losses have been quite dramatic. However, investors who have been willing to invest in stocks for long periods of time generally see strong positive returns.
Bonds are generally less volatile than stocks but offer less chance for large returns.
An investor who is getting close to a financial goal would likely upped their bond holdings in favor of stocks. Although stocks have more potential for growth, bonds are seen as being less of a risk.
Some bonds offer returns that are similar to those of stocks. However, these bonds, called high-yield or junk bonds, also have more risk.
Types of cash and cash equivalents that offer the lowest return on investment include savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds.
The amount of money you could lose from investing in this asset is usually very low. The federal government guarantees many investments in cash equivalents.
Although investment losses in non-guaranteed cash equivalents do happen, they are not common. Cash equivalents are a type of investment that is low risk but also has a low return, which can be a concern for investors because it may not keep up with inflation. The risk that inflation will reduce the purchasing power of investments over time.
There are three main types of assets: stocks, bonds, and cash. There are several asset categories from which you can choose when investing in a retirement savings program or college savings plan.
Other types of assets exist besides stocks and bonds, including real estate, precious metals, commodities, and private equity. Some investors may choose to include these asset types in their portfolio.
Investments in these asset categories typically have category-specific risks. Before making any investment, you should be aware of the risks involved so that you can make sure they are appropriate for you.
Asset Allocation By Risk Tolerance
How much an investor is willing to lose is an important factor in deciding how to spread their investment among different assets.
If you are risk-averse, it is a good idea to put more of your money into safer assets such as bonds and cash. This will help to balance out the risk in your portfolio.
Investors looking to reduce the risk in their portfolio may want to consider investing in asset classes that have little correlation to stock and bond markets, such as real estate and commodities like gold.
If you have a higher risk tolerance, you should put more of your money into equities like stocks.
Some people are more willing to take risks than others. How much risk someone is willing to take also depends on what stage of life they are in or what their future plans are.
A young investor might not be able to handle losing money, so they would rather invest in things that are less likely to lose value.
A risk-tolerant investor would not adjust their investment allocate after a life change, whereas a more risk-averse investor would.
An investor should shift their allocation to less risky assets if they plan to use a portion of their investments to fund a large future expenditure. This makes sense because it will minimize the chance of losing money on the investment.
A diversified portfolio should contain a variety of different asset categories, as well as a variety of investments within each category.
You will need to allocate your investments not only among different asset categories like stocks, bonds, cash equivalents, etc., but also within each separate asset category.
The key is to invest in different segments of each asset category so that you will make money even if the market conditions are not ideal.
You can diversify your investments by investing in a wide range of companies and industry sectors.
Your investment portfolio won’t be diversified if you only invest in a few individual stocks. At least 12 stocks are needed to be properly diversified.
Some investors may find it easier to diversify their assets by owning mutual funds rather than individual investments from each asset category.
A mutual fund is a company that manages a collective investment fund on behalf of its investors, all of whom share the same financial goals. The fund invests in a variety of assets, including stocks, bonds, and other financial instruments. Mutual funds provide investors with an easy way to own a small portion of many investments.
An example of a total stock market index fund would be one that owns stock in thousands of companies. That’s a lot of diversification for one investment!
While mutual fund investments can provide diversification, this may not be the case if the fund focuses on a single industry sector.
If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get the diversification you seek. This is because each mutual fund will have a different focus, and by investing in multiple mutual funds you can get a more diverse portfolio.
When allocating assets, it is important to consider different types of investments, such as large company stock funds, small company stock funds, and international stock funds.
When thinking about investing in different asset categories, you may want to consider stock funds, bond funds, and money market funds. If you add more investments to your portfolio, you will have to pay more fees and expenses, which will reduce your investment returns.
You need to take these costs into account when deciding how best to spread your investments around.