Investing always comes with risks that a wise investor, whether big or small, should take pains to manage. One way to do so is by ensuring that your money is spread across different types of investments.
There are different asset classes, the most common being stocks, bonds, cash, real estate, precious metals and commodities, and even private equity.
Each one carries a different set of risks and rewards and behaves differently in various circumstances. Since there is no way of telling how one asset or investment vehicle will perform, you would not want to put all your hard-earned money into just one asset class. Just imagine: You put all your money in a single stock, and the company that issued that particular stock does not perform as expected. Then you would have lost much, if not all your money.
This is why diversification, or putting your funds in different investments such as stocks, bonds, and cash, is important. Assets or investment classes do not move up or down at the same time. To illustrate, when stocks do well, fixed-income and bonds usually don’t have good returns since the market conditions that favors one asset class tend to work against another.
In a nutshell, diversifying through asset allocation helps you reach your financial goals in two major ways: it protects you against significant losses, and it increases your chances of getting better returns on your investment.
There is no cut-and-dried formula on how to allocate your assets, as this depends on your personal and financial circumstances. However, there are some useful points to help you arrive at an optimal mix that works best for you.
1. Determine the appropriate mix of assets for your needs.
This mix is a dynamic one that will change depending on your financial goals. There are two major factors that should guide you in determining asset allocation: one is time horizon, or how long you can stay invested. The longer your time horizon, the more risk you can take on because you can wait out the up and down cycles of the markets. The second is risk appetite or your willingness to accept the possibility of losing part or even all of your original investment in exchange for the possibility of getting much bigger returns. If you are willing to embrace more risk, then you can have more high-risk but high-yielding instruments in your asset mix.
2. Diversify among asset categories and within asset categories.
It is not enough to diversify among different asset categories, like deciding that 40% of your money will go into stocks and 60% will go into fixed-income securities. For the 40%, you can also diversify among different shares of stock so that your holdings include a number of individual stocks in different industries or sectors. Most conservative investors tend to stick to blue chip stocks, while others are on the lookout for the next big thing. A mix of both may be good to explore, again depending on your time horizon and risk appetite. For the 60%, also search for individual bonds representing companies that perform differently in various conditions.
3. Revisit to know if you need to rebalance.
From time to time, you might need to change the allocation of your assets. This may be because of changes in your financial goals, or life circumstances say you just got married or had a child, or time horizon. For instance, if you are suddenly widowed, you may realize that you want to be more conservative in your investment approach, necessitating a shift in your asset mix. Another reason to rebalance is if there is a considerable change in the value of one asset class. Let’s say there is a tremendous stock market rally that inflates the value of your equities and changes the proportions of the assets in your portfolio. It’s always good to seek professional financial advice before making significant shifts, especially if it will involve fee payouts.
4. Consider actively managed funds.
A quick and easy way to diversify your holdings is to put your money into mutual funds which are pooled funds invested in a variety of asset classes. Unless you have the expertise and the time to manage your portfolio, consider tapping investment houses with a solid reputation. Exchange traded funds also allow you to diversify quickly and conveniently. Of course, you will need to find a fund that matches your investment goals and time horizon.
5. Consult a financial professional.
If you need guidance on how to go about allocating your assets, call a financial professional to help you understand how to achieve your goals. Some banks or financial companies offer this service for free, with no obligation to purchase their products or funds. Take advantage of this complimentary service. There are also independent portfolio managers that for a fee can help you decide where to invest your money, and how best to allocate your assets. Key here is to shop for options, and then choose the best one for you.