One of the most important decisions for your investment portfolio is your choice of asset allocation. Asset allocation simply means spreading investments over a variety of asset categories, such as equities, cash or cash alternative investments, bonds, real estate, foreign securities, and possibly even precious metals and collectibles. How you allocate your assets depends on several factors, including your investment objectives, attitudes toward risk and investing, desired return, age, income, tax bracket, time horizon, and even your belief in what the market will do in the near term and long term.
Example(s): Let’s say your investment objective is substantial asset growth, you have a 10- to 15-year horizon, and you are willing to assume a high amount of risk. You might choose to place a larger percentage of your funds in stocks of newer, growing companies that may offer higher return but involve a greater degree of risk. In contrast, another investor with a 5-year time horizon, whose objective is preservation of principal and who doesn’t want substantial risk, may invest more heavily in government or banking instruments. Your asset mix, the specific investments you choose within each asset category, and the timing of your investments all play a part in your overall return.
The underlying principle in asset allocation is the documented observation that different broad categories of investments have shown varying rates of return and levels of price volatility over time. By diversifying your investments over asset classes, you potentially reduce risk and volatility. Downturns in one investment class may be tempered (or even offset) by favorable returns in another. Just as using different asset categories within a portfolio has the potential to reduce your risk, your choice of individual assets within a class can do the same. For instance, choosing stocks from different industries (e.g., automotive, high technology, retail, or utilities) within your stock allocation can be less risky than investing all of your stock allocation in one industry or company.
Caution: It is important to note that asset allocation does not guarantee a profit or protect against loss in a declining market. Asset allocation is a method used to help manage risk.
Generally, the higher the expected return on an investment, the higher the risk involved in trying for that return. The longer your investment time horizon, the more volatility you may be able to handle, allocating more of your investment to higher-risk (aggressive) assets. With a longer-term investment horizon, you have a better opportunity to ride out several economic cycles. A shorter time frame usually requires a more conservative approach because you have less time to try to recuperate from a market downturn. In that case, you may want to reallocate investments into a lower volatility mix of asset classes as the time approaches to convert your investments to cash for a particular goal.
The following information is reprinted with permission from Forefield, Inc. Copyright 2006-2010.