Aug 13 · 3 min read
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Asset Allocation is one of the most important concepts in investing. Even if you’re new to investing, you probably already understand this strategy. This is because you see it every day in the real world. Ever been to a store that sells more than one product? Well if you have, you’ve seen asset allocation in action. Businesses carry a variety of products to minimize the risk of losing money. If all of the store’s products are selling well, then great! But if one of the store’s products isn’t being bought, the revenue from the others can offset this poor performance. This is exactly how asset allocation in investing works.
When implementing the asset allocation strategy, you will divide your money over different asset classes like stocks, bonds, and cash. This allows you to minimize your risk of losing money through creating a diverse portfolio. For example, if your stocks aren’t doing well, your bonds and savings accounts can make up for it. Let’s take a closer at the three main asset classes you should choose from.
Up first are stocks. Stocks have historically been the riskiest but most rewarding asset class out of the three. Although they can be volatile, investing in stocks over a long period of time has proven to be one of the best ways to grow your money.
Next, are bonds. Bonds are a way for you to loan your money to companies or the government in exchange for interest. Although bonds are not risk-free, they are generally less risky than stocks. You can purchase bonds through bond-focused ETFs and mutual funds, directly from a bond broker, or directly from the government (https://www.treasurydirect.gov/ for U.S. investors).
Last but not least is cash. Allocating your money to cash means placing it in extremely low-risk accounts like savings accounts, CDs, and money market accounts. These tend to be poor long term investments, but serve as the best options if you cannot afford to lose a dollar of your money.
Determining what percentage of your money should go into each asset class will depend on two factors: the time left to reach your financial goals and how much risk you can tolerate.
When it comes to timing, you will need to decide when you want to reach your financial goals. Generally, the longer your time horizon, the more stocks you should own. This is because you have more time to withstand the ups and downs of the stock market. Investors who are getting closer to reaching their financial goals, such as retirement, are recommended to allocate more of their money to bonds and cash. As we all know, the stock market can crash at any time and by large amounts. If you’re nearing your financial goals, it might be beneficial to lower your exposure to stocks and allocate more money to lower risk assets like bonds and cash.
The second important factor in asset allocation is risk tolerance. All investments have some level of risk, but some investments have more than others. The more risk you’re willing to take, the more money you should allocate to stocks. If you’re wanting to play it safe, you should instead invest in low-risk bonds and cash.
While every investor's financial situation is different, there is a general rule of thumb that can help you allocate your money. Although not perfect, many experts recommend subtracting your age from 110 or 120 to determine how much of your investments should be stocks. The rest should then be allocated to a mix of bonds and cash. As an example, if you’re 28 years old, you should allocate 82-92% of your investments to stocks and the rest to bonds and cash. Although there is no one right way to allocate your assets, this rule can serve as a great starting point.
Once you’ve divided your money over the three asset classes, it is important to rebalance your investments every six or twelve months. Rebalancing your investments means buying and selling different assets to make sure your allocation percentages are as you planned.
For instance, Wanda is 30 years old with an asset allocation of 80% stocks, 15% bonds, and 5% cash. After a year of strong performance from the stock market, her portfolio is now 90% stocks, 8% bonds, and 2% cash. Since she is now 31, she wants her investments to be only 81% stocks. To make this happen, Wanda has two options: she will need to either sell some of her stocks and move this money to bonds and cash or simply just buy more bonds and cash assets until stocks are 81% of her total portfolio. Because of potential taxes from buying and selling assets, many investors choose to just buy more of the assets that are underweight in their portfolio.
Whether you’re just getting started or nearing retirement, it's always a perfect time to start applying asset allocation. Decide how much longer you have to reach your financial goals, along with your risk tolerance, and start investing whyzely.
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