Asset allocation and diversification don't guarantee a profit or insure against a loss. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
The combination of investments you choose can be as important as your specific investments.
The mix of various asset classes, such as stocks, bonds, and cash alternatives,
account for most of the ups and downs of a portfolio's returns.
Deciding how much of each you should include is one of your most important tasks
as an investor. That balance between potential for growth, income, and stability
is called your asset allocation. It doesn't guarantee a profit or insure against
a loss, but it does help you manage the level and type of risks you face.
Balancing risk and return
Ideally, you should strive for an overall combination of investments that can help to minimize
the risk you take in trying to achieve a targeted rate of return. This often means
balancing more conservative investments against others that are designed to provide
a higher return but that also involve more risk. For example, let's say you want
to get a 7.5% return on your money. Your financial professional tells you that in
the past, stock market returns have averaged about 10% annually, and bonds roughly
5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix
of stocks and bonds. It might not work out that way, of course. This is only a hypothetical
illustration, not a real portfolio, and there's no guarantee that either stocks
or bonds will perform as they have in the past. But asset allocation gives you a
place to start.
Many publications feature model investment portfolios that recommend generic asset
allocations based on an investor's age. These can help jump-start your thinking
about how to divide up your investments. However, because they're based on averages
and hypothetical situations, they shouldn't be seen as definitive. Your asset allocation
is--or should be--as unique as you are. Even if two people are the same age and
have similar incomes, they may have very different needs and goals. You should make
sure your asset allocation is tailored to your individual circumstances.
Many ways to diversify
When financial professionals refer to asset allocation, they're usually talking
about overall classes: stocks, bonds, and cash or cash alternatives. However, there
are others that also can be used to complement the major asset classes once you've
got those basics covered. They include real estate and alternative investments such
as hedge funds, private equity, metals, or collectibles. Because their returns don't
necessarily correlate closely with returns from major asset classes, they can provide
additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example,
if you're investing in stocks, you could allocate a certain amount to large-cap
stocks and a different percentage to stocks of smaller companies, or allocate
based on geography.
Bond investments might be allocated by various maturities, with some money in bonds
that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds
over taxable ones, depending on your tax status and the type of account in which
the bonds are held.
Monitoring your portfolio
Even if you've chosen an asset allocation, market forces may quickly begin to tweak
it. For example, if stock prices go up, you may eventually find yourself with a
greater percentage of stocks in your portfolio than you want. If they go down, you
might worry that you won't be able to reach your financial goals. The same is true
for bonds and other investments.
Do you have a strategy for dealing with those changes? Of course you'll probably
want to take a look at your individual investments, but you'll also want to think
about your asset allocation. Just like your initial investing strategy, your game
plan for fine-tuning your portfolio periodically should reflect your investing personality.
Even if you're happy with your asset allocation, remember that your circumstances
will change over time. Those changes may affect how well your investments match
your goals. At a minimum, you should periodically review the reasons for your initial
choices to make sure they're still valid. Also, some investments, such as mutual
funds, may actually change over time; make sure they're still a good fit.