- What is Asset Allocation?
If you ever heard the saying, "don't put all your eggs in one basket," you've already gained a valuable piece of wisdom in asset allocation. In fact, some of the most fundamental principles of investing can be drawn from your everyday experiences. With your natural instincts and the right resources, you can be on your way to making many sound investments.
By definition, asset allocation is the approach of dividing your money across a variety of investments. Typically, investors will put their capital into asset categories such as stocks, bonds and cash equivalents, to develop their portfolio. That can sound pretty confusing, but don't worry - we'll go over all of the technical stuff soon.
By picking the right mix of investments, you'll always be in a position to withstand any changes in the market - without sacrificing too much of your gains. But before you decipher your best investments, you'll have define your investor profile. In the next section, we'll review the two critical factors to your asset allocation.
- The pillars of asset allocation
The way you choose to allocate your assets will be unique to your situation. However, two variables define you as an investor above all else: your timeline and risk tolerance.
Time. The investment mix that's best for you will change according to your age and your stage of life. You'll have to consider how much time you have to meet a financial goal and whether you expect to invest for months, years, or decades. When you have a longer timeline, you have more liberty to take on volatile investments as time gives you the ability to withstand economic turbulence. You just have to predict where the market will eventually settle. On the contrary, an investor that is transitioning to retirement would likely prefer to take on less risk because he or she has a shorter investment timeline.
Risk tolerance. All investments have some level of risk that can result in some or all of your capital to be lost. Your readiness to lose your investment, either wholly or partially for bigger returns, defines your risk tolerance. A conservative investor who prefers low-risk investments will opt for securities that are more likely to preserve his or her initial investment. By contrast, an aggressive investor is willing to lose money on high-risk investments to achieve a more profitable outcome. Thus, risk and reward are two sides of the same coin. The reward for taking risks is the potential for higher returns.
Defining these primary attributes will you help narrow down the investments that match up with your distinct needs. If you have a lofty goal for your wealth and an ample timeline, it's likely that you'll do better to diversify your money on asset categories with higher risk. Alternatively, low-risk asset classes can account for a large percentage of your portfolio if you have a shorter timeline for reaching your goals.
In the next few sections, we'll review the main asset classes. Don't forget to bookmark this page and save it to the home screen of your smartphone or tablet. You can return to use this tool as your timeline or appetite for risk changes. If you find this page useful, please follow us and promote us on social media by using the share feature.
- Asset Categories
If you are new to investing, you'll soon realize there's a plethora of securities to choose from - each with different pros and cons. Most investors tend to diversify their money among three main asset categories: stocks, bonds, and cash investments. If that isn't daunting enough, within each asset category is another slew of investment products.
The best strategy spreads out through all the major categories and their subdivisions to balance risk and reward. Follow along with the next three sections, to learn the essential characteristics of each asset class.
Of the asset classes, stocks tend to present the highest risk investments. By definition, stocks are shares of a business or corporation. Companies issue stocks to raise capital to grow their brand and take on new developments. When an investor purchases stocks, they become a shareholder of the company. Then, when the company makes a profit, it pays dividends to each shareholder. Stock prices can move up and down based on what's happening in the economy, so your exact earnings (or losses) can fluctuate too.
You'll find a vast array of options within the stock market, some of which can pose more risk than others. Typically, stocks can be divided into risk categories based on the total value of the company shares. If you multiply the current share price by its number of outstanding shares, you get the corporation's market cap. The company's market cap is its initial risk assessment.
Small cap: These are the businesses that offer a lesser volume of shares and generally have a market cap under $2 billion. Small-cap companies will have more room to grow than an established corporation, but also possess a higher chance of failure. If you look at any corporate giant, you'll notice that their most notable growth was in their early years. As a result, investing in small-cap stocks comes with more risk and volatility (if the company makes the wrong move), but can offer the most significant returns in the market. Aggressive investors are more likely have involvement with small-cap stocks due to their potential profitability.
Mid-cap: Companies that are considered mid-cap have approximately $2 billion to $10 billion shares circulating in the market. A mid-cap company will have more stability than a small cap stock because it has already started to stabilize its growth cycles. That said mid-cap companies typically still have potential to expand. That makes mid-cap stocks more likely to appeal to individuals with moderate risk tolerance.
Large-cap: Large-cap companies, with a market cap over $10 billion, account for the majority of the shares circulating in the stock market. These are well-established global corporations like Apple, Google, and Tesla (to name a few). They can move and influence the market due to their immense size. Because they are established market leaders, big-cap companies pose the lowest risk to investors and should represent a significant portion of any investment portfolio. These corporations tend to provide consistent (and more modest) returns and are most likely to preserve your initial investment.
Foreign stocks: international stocks can present a unique opportunity to diversify. Overall the global economy has been steadily improving, which opens up the door for many emerging markets. Prospects include many European nations, Japan, and areas in the Middle East like UAE that show promising returns in specific industries.
Regardless of the mix you choose, you'll have to do extensive research on the companies and industries that appeal to you, to make a worthwhile investment. Investors would do well to expand their portfolios by buying into different sectors with various market caps, earnings and growth potentials.
Of the asset categories, bonds represent a high to moderate risk investment. By definition, a bond is an investment loan that is given to an entity for a period of time. Companies, states, and municipalities will issue bonds to fund new projects, instead of getting money from a bank. The bond issuer will then pay their investors in the form of fixed or variable interest payments until the fund reaches maturity.
Like stocks, bonds have categories and classifications that define their individual risk. Bonds can be separated into municipal or corporate funds and given ratings from Aaa (low risk) to junk bonds (high risk).
Municipal bonds. Munis are bonds that are issued by states and municipalities. These bonds are used to finance different government project in local counties such as road and sewer maintenance. Municipal bonds tend to offer smaller returns than corporate bonds that are taxable. As a trade-off, the earnings from a muni are typically exempt from federal and state taxes. These types of bonds tend to appeal to high earners with moderate risk tolerance, due to the potential of double tax-free yields.
Corporate bonds. These are debts issued by a company, which get sold off to investors. Corporate bonds tend to confer higher risk and give better returns than municipal bonds. However, a corporate bond can still be a safer investment than company stocks. If a company loses value or goes into bankruptcy, the bondholders will always get their payments (and return of capital) ahead of the shareholders.
Some other bond investments are relatively new in the bond market called inflation-protected securities, mortgage-backed securities, and asset-backed securities. These funds offer an additional level of protection to investors. The bonds returns are either adjusted for inflation or secured by assets like a collection of mortgages.
Ultimately, each type of bond will have different interest rates and credit risks. In many instances, the subclasses of bonds, whether corporate or municipal, will not perform in the same manner. Selecting a mix of well-researched bonds in the right industries can reduce your risk and increase your returns.
Typically, cash investments are considered the lowest risk of all the asset classes. Investors can choose between savings accounts, CDs, treasury notes, and money market funds. Most options tend to be very stable and highly liquid. As a result, the returns tend to be very modest too.
Savings accounts. These accounts are offered by all banks and credit unions and tend to be federally insured against losses. Returns rates are relatively low (approximately 0.25%) with slightly better rates for online accounts.
CDs. Certificates of deposit are available through most banks and credit unions. These accounts offer better returns with more substantial deposits and longer maturities. Any money allocated to a CD must be kept in the account for 1 year or 5 years. Once the account reaches its maturity, the earnings can be reinvested to the CD if it is renewed.
Treasury notes These money instruments are fully backed by the government. Notes are issued from 2 to 10 years and earn fixed interest semi-annually (twice a year). Also, some notes can be purchased at a discount and exchanged for the full face value at maturity.
Money market funds. Money market funds give investors access to a diversified pool of cash investments. Most of the funds are high quality, liquid debts with short maturities. As a result, risk and returns are extremely low. Typically, these securities alone are not the best choice for meeting long-term financial goals.
It's true; cash investments provide nominal returns. However, they can be useful in your portfolio for many reasons. Some instruments can be helpful to reach short-term objectives, like saving up your home down payment. Then you can move between stable and more volatile investments as you transition through different stages of your life. When you maintain liquid assets, you have the power to move your money around as sudden opportunities arise.
Even though one asset class can be higher risk than another, many investment options can have similar risk profiles. It's critical to do your research and then compare your options before investing. That is the main point of allocation and diversification - to take risks under a safety net. Because without taking calculated risks, it's likely that you'll struggle to meet your investment goals.