Asset Allocation and Diversification
What is Asset Allocation?
Asset allocation is the practice of making sure that an investment portfolio covers different asset categories, such as stocks, bonds, cash, and real estate. The proper asset allocation or "right-mix" of assets is based on an investor's age, level of risk tolerance, and financial goals.
To figure out the best asset allocation, an investor first needs to understand the time horizon in which he or she is investing. For example, a 25-year old has a much longer investing time horizon than a 60-year old. The 25-year old should be more comfortable with a higher percentage of riskier assets like stocks than a 60-year old. Because of the longer time horizon, the 25-year old will be better able to ride out volatile market swings and wait out periods of slow growth. An older investor, especially one nearing retirement, can't risk losing a large portion of a portfolio in the event of a market downturn. The portfolio of older investors will then swing more toward bonds and fixed-income assets.
Risk tolerance is about an investor's ability to deal with volatility. For example, aggressive investors often have a high-risk tolerance. They're able to deal with the ups and downs of the markets because they believe in the long-run, they'll make more money than they'll lose. Conservative investors can't sleep at night if their investments lose money one day and gain it the next. They prefer a much slower rate of growth if it means that their original investment won't be lost.
All investors need to establish solid reasons for saving and investing. For some, the financial goal of saving and investing is retirement. For others, it's about saving for a child's college education. Defining the purpose of investing is also part of understanding how risk and reward relate to investing. Even a conservative investor has to take some risk in order to see a gain. Growth investments, especially those that are in the portfolio after retirement, need to increase at least at the rate of inflation.
Guidelines for Asset Allocation
While the proper balance of asset allocation is a unique and based on personal choice, there are some guidelines. Generally, investors in their 20s, 30s, and 40s should have up to 90% of their retirement accounts in stocks and 10% in bonds because fixed-interest instruments simply don't offer enough growth. Even given the serious decline in the stock market over the past several years, stocks have returned an average of 10% per year over the past 70 years, compared to the 5% yield of bonds Younger investors, especially those who are just starting out, may not make very much money. And while it's important to save even a small amount every month, the largest "bang for the buck" will come from stocks.
What is Diversification?
Diversification is about holding different investments within asset classes. In other words, the asset class of stocks can be further broken down into types of stocks. For example, investing in a broad range of companies and market sectors is one way to diversify. The basic materials sector moves independently of the financial sector, so holding a stock from each of these categories usually means that even if one is down the other could be up.
Further diversification can be achieved by investing in mutual funds or exchange traded funds that invest in foreign countries. The economy of China is independent of the economy of Chile. And small cap stocks often move differently than large cap stocks. While the global economy can move as one large market during a world economic crisis, in general, diversification of assets will protect a portfolio against crashes.
The Importance of Asset Allocation and Diversification Over Long Periods of Time
Asset allocation and diversification are equally important to the total amount of money that's contributed to a retirement account each month. If you're in the market for the long-haul to save for retirement, that's 30-50 years of investment. Your actions should be geared towards slowing building portfolio value while at the same time locking in that wealth. Even if you hit a 10-year lucky streak picking technology stocks, one bad sector crash could wipe out all of those gains in a matter of months. That's why successful investors adjust their portfolios every year to make sure that their wealth is evenly distributed across various assets classes and individual investments.
Rebalancing a Retirement Portfolio as You Age
Investors in their 40s and 50s should begin the process of assessing the value of their accounts and rebalancing based on what they have and where they need to be. While it's ok to keep a large portion of the portfolio in stocks, the allocation should change to 80% stocks and 20% bonds. But the level of risk tolerance typically decreases with age, so some middle-aged investors may want to create a more conservative allocation by placing 70% of the portfolio in stocks and 30% in bonds.
In their 60s, investors should not hold more than 60 to 65% in stocks. Because stocks are more volatile than bonds, investors need to make sure that the gains they've achieved over the past several decades aren't lost. Sometimes, it takes the market a very long time to regain the amount it has lost.
Those in their late 70s also need to maintain a percentage of stocks in order to make sure the portfolio outpaces inflation. While holding 55% in stocks is recommended, some investors may sleep better at night if the percentage is under 50%. Growth of the accounts will also mean that a portion of the money that's being withdrawn each month will be replaced. In other words, those who are able to replace a portion of what they're spending each month will have less of a chance of running out of money later in retirement.
Finally, after retirement, the allocation should include 40% to 50% stocks with the remaining balance in bonds and cash. It's important to note that those over the age of 70 ½ who have begun taking mandatory distribution from tax-qualified accounts can use the distributions to purchase safe-harbor investments such as money market funds and certificates of deposit. Even though the accounts will now be subject to income tax, they'll continue to earn interest.
What a Retiree's Portfolio Should Look Like
First and foremost, a retiree needs to protect assets. However, he or she also needs to make sure that the investments are growing faster than the rate of inflation. While keeping too much money in stocks isn't safe, neither is keeping too much in cash or CDs.
One investment option for retirees is annuities. While they aren't right for everyone, annuities may be ideal for retirees who want to protect assets and make sure they have guaranteed income for life. A fixed immediate annuity can guarantee a set monthly payment even if you live into your 90's, eliminating the fear outliving your income. Annuities are best for investors who haven't saved enough for retirement or who are more comfortable knowing that they have a guaranteed amount of income coming in each month.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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