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Asset allocation
Asset allocation is the process of spreading your investments across the three major asset classes of stocks, bonds, and cash.
Asset allocation is a very important part of your investment decision-making. Professional financial planners frequently point out that asset allocation decisions are responsible for most of your investment returns.
Asset allocation begins with setting up an initial allocation. First, you should determine your investment profile. Specifically, this requires you to assess your investment horizon, risk tolerance, and financial goals:
- Investment horizon. Also called time horizon, your investment horizon is the number of years you have to save for a financial goal. Since you're likely to have more than one goal, this means you will have more than one investment horizon. For example, saving for your five-year-old daughter's college has an investment horizon of 12 years. Saving for your retirement in 30 years has an investment horizon of 30 years. When you retire, you will want to have saved a lump sum that is large enough to generate earnings every year until you die.
- Risk tolerance. Your risk tolerance is a measure of your willingness to accept a higher degree of risk in exchange for the chance to earn a higher rate of return. This is called the risk-return trade-off. Some of us, naturally, are conservative investors, while others are aggressive investors.
Generally, the younger you are, the higher your risk tolerance and the more aggressive you can be. As a result, you can afford to allocate a higher percentage of your investments to securities with more risk. These include aggressive growth stocks and the mutual funds that invest in them. A more aggressive allocation is viable because you have more time to recover from a poor year of investment returns.
- Financial goals. Your financial goals are also an important consideration in deciding on an initial allocation. For example, if you want to save $40,000 for your daughter's college in another 12 years, you will have to invest more aggressively than if your goal is only $20,000.
If you invested $2,000 at the beginning of each of the next 12 years in a college savings plan, invested at an annual rate of return of 8%, you would reach your goal of $40,000. If you thought you needed $60,000, however, you would have to either invest $2,950 a year, or increase your expected rate of return to 13.5%.
Generally, younger and aggressive investors allocate 70% to 100% of their portfolios to stocks, with the remainder in bonds and cash. Conservative investors allocate 40% to 60% in stocks, 30% to 50% in bonds, and the remainder in cash. Moderate investors allocate somewhere between the allocations of aggressive and conservative investors.
To make an initial allocation, you need to build a portfolio of individual securities, mutual funds, or both. In general, mutual funds provide more diversification benefit for the buck.
How you choose to precisely allocate among the major asset classes depends, in part, on other factors. For example, if interest rates are expected to rise, you might allocate a greater percentage to money market mutual funds, CDs, or other bank deposits. If rates are headed lower, you may choose to allocate more to stocks or bonds.
Financial planners suggest that you rebalance, or reallocate, your portfolio from time to time. They differ in their views on how often you should reallocate. It may be once a year, or it may be every three to six months. At a minimum, reallocation lets you update any changes in your investment profile, or to take advantage of a change in interest rates. Rebalancing often involves nothing more than a "fine-tuning" of your current allocations. For example, a conservative investor may decide to shift 5% of her portfolio from stocks to cash to take advantage of higher rates that money market funds may be offering.
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