Asset Allocation – Broken Down

Reality check: If your financial advisor, stock broker or hedge fund manager was able to see the future and know which way the market was heading, they wouldn’t be managing your money.

Instead they would invest the farm on their market prediction and ride off into the sunset.

That is the cold hard truth….

And because they cannot see the future (even thought they might continue to tell you otherwise) they should be helping you invest your money in an appropriate asset allocation portfolio tailored to your goals and objectives.

What the heck does that mean?????

Allow me to break it down for you.

The basics of asset allocation

The idea behind asset allocation is that because not all   investments are alike, you can balance risk and return in your portfolio by spreading your investment dollars among different types of assets, such as     stocks, bonds, and cash alternatives. It doesn’t guarantee a profit or ensure  against a loss, of course, but it can help you manage the level and type of  risk you face.

In my experience, that is the most important piece of the puzzle.

If your portfolio behaves in a way you expect (knowing that it can up and down) should prevent you from making bad, irrational investment decisions.

Different types of assets carry different levels of risk and   potential for return, and typically don’t respond to market forces in the same way at the same time.

For instance, when the return of one asset type is declining, the return of another may be growing (though there are no guarantees). If you diversify by owning a variety of assets, a downturn in a single holding won’t necessarily spell disaster for your entire portfolio.

Using asset allocation, you identify the asset classes that  are appropriate for you and decide the percentage of your investment dollars that should be allocated to each class (e.g., 70 percent to stocks, 20 percent  to bonds, 10 percent to cash alternatives).

The three major classes of assets

Here’s a look at the three major classes of assets you’ll  generally be considering when you use asset allocation.

Stocks:

Although past performance is no guarantee of future results, stocks have historically provided a higher average annual rate of  return than other investments, including bonds and cash alternatives. However,   stocks are generally more volatile than bonds or cash alternatives. Investing  in stocks may be appropriate if your investment goals are long-term.

Bonds:

Historically less volatile than stocks, bonds do not  provide as much opportunity for growth as stocks do. They are sensitive to interest rate changes; when interest rates rise, bond values tend to fall, and  when interest rates fall, bond values tend to rise. As a result, bonds redeemed prior to maturity may be worth more or less than their original cost. Because bonds typically offer fixed  interest payments at regular intervals, they may be appropriate if you want  regular income from your investments.

Cash alternatives:

Cash alternatives (or short-term     instruments)  offer a lower potential for growth than other types of assets but are the least  volatile. They are subject to inflation risk, the chance that returns won’t     outpace rising prices. They provide easier access to funds than longer-term  investments, and may be appropriate for investment goals that are short-term.

Broken Down Further

Not only can you diversify across asset classes by  purchasing stocks, bonds, and cash alternatives, you can also diversify within  a single asset class.

For example, when investing in stocks, you can choose to  invest in large companies that tend to be less risky than small companies.

Or, you could choose to divide your investment dollars according to investment style, investing for growth or for value. Though the investment possibilities   are limitless, your objective is always the same: to diversify by choosing  complementary investments that balance risk and reward within your portfolio.

Decide how to divide your assets

Your objective in using asset allocation is to construct a  portfolio that can provide you with the return on your investment you want  without exposing you to more risk than you feel comfortable with. How long you   have to invest is important, too, because the longer you have to invest, the  more time you have to ride out market ups and downs.

When you’re trying to construct a portfolio, you can use  worksheets or interactive tools that help identify your investment objectives, your risk tolerance level, and your investment time horizon. These tools may  also suggest model or sample allocations that strike a balance between risk and  return, based on the information you provide.

For instance, if your investment goal is to save for your  retirement over the next 20 years and you can tolerate a relatively high degree  of market volatility, a model allocation might suggest that you put a large percentage of your investment dollars in stocks, and allocate a smaller percentage to bonds and cash alternatives.

Of course, models are intended to serve only as general guides; determining the right allocation for your  individual circumstances may require more sophisticated analysis.

Build your portfolio

The next step is to choose specific investments for your portfolio   that match your asset allocation strategy.  Websites like Morningstar.com or finance.google.com (not endorsed by IFS securities) you can investigate most of the funds available to you in your brokerage or retirement accounts.   You can search by asset class, risk level etc..

Pay attention to your portfolio

Once you’ve chosen your initial allocation, revisit your  portfolio at least once a year (or more often if markets are experiencing greater short-term fluctuations). One reason to do this is to rebalance your     portfolio. Because of market fluctuations, your portfolio may no longer reflect the initial allocation balance you chose. For instance, if the stock market has  been performing well, eventually you’ll end up with a higher percentage of your  investment dollars in stocks than you initially intended. To rebalance, you may   want to shift funds from one asset class to another.

In some cases you may want to rethink your entire allocation strategy. As you get older or just closer to end date of your goals you should make sure the allocation strategy is still appropriate for you.

Wrap Up

Money is lost in the markets due to emotional decisions that cause us to take action at the wrong times.   Building a properly allocated portfolio is one of the major keys to investment success. Investing is not about loading up on one investment that you think (guess) is going to sky rocket, it’s about building a portfolio that will perform in manner that you can expect and handle.

As always, you can consult with me to discuss  your current portfolio and allocation.

Look for future posts on the best ways to mange your inheritance   and check out my recent post on retirement income planning.

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Thanks for stopping by and I hope you achieve financial success!