At first glance, successful investing may seem to be all about picking winning stocks. However, it’s actually about balanced portfolio management that truly serves your goals, timeline, and personal comfort with investment risk.
Asset allocation is the process of spreading your investments across multiple asset classes, including stocks and bonds. Diversifying your portfolio in this way helps you maximize long-term growth, manage potential risks, and create a plan that can weather a range of market conditions.
Smart allocation is one of an investor’s most powerful tools for building wealth and financial security while maintaining optimal control over their financial strategy. In this comprehensive guide, we’ll go over some of the most important investing basics to know.
Main Types of Asset Classes
Understanding the major classes of assets is the first step toward creating a portfolio that aligns with your long-term plans. Here are the key types to know.
Stocks
Stocks represent ownership in a company or business. They also come with the potential for high returns, especially over time, making them very attractive to investors focused on long-term wealth-building.
However, stocks can also be volatile. Factors like economic trends, corporate performance, and even current events can drastically impact their value. However, investing in diversified stock options like ETFs and mutual funds can help offset some of the potential risk.
Bonds
A bond is essentially a loan to a government or a corporation in exchange for benefits like regular interest payments and the return of the original principal at maturity. Bonds are generally a lot more stable than stocks, with significantly less dramatic value fluctuations.
However, while bonds are considered low-risk assets, they still bring challenges to the table. For example, rising interest rates can effectively reduce the value of an existing bond.
Cash alternatives
Cash, as well as cash equivalents like savings accounts or treasury bills, are liquid and carry a very low risk, especially compared to other options. They don’t yield the same high returns, especially during periods when interest rates are low, but they do provide quick access to necessary funds.
Cash and cash equivalents are ideal for creating emergency savings or maintaining any funds you may need to access in the short term.
Other alternative assets
Many investors eventually add additional assets to their overall wealth-building strategy. Popular examples include real estate, hedge funds, private equity, and commodities (such as oil or gold).
These assets offer another level of diversification, as their value doesn’t typically fluctuate along with that of stocks or bonds. However, associated risks and fees can be higher. These assets are also less liquid than the alternatives.
The Importance of Time and Risk Tolerance
Creating a strong allocation strategy starts with thorough consideration of two key factors – how long you plan to invest and how much potential risk you’re willing to take on.
Time horizon
Your investment time horizon is the length of time you plan on holding onto the investments you make before actually needing to access the money. It should also have a significant influence on your allocation strategy.
For example, younger people with decades to go before they’ll be thinking seriously about retirement will have time to recover from serious market downturns. This being the case, they have more freedom to invest in stocks and take on higher risks.
However, someone looking to buy a house within the next five years may be thinking more short-term. This should inspire a more conservative approach that involves higher allocation to bonds or cash.
Risk tolerance
Your risk tolerance refers to both your ability and willingness to potentially endure financial losses in investment value. Factors that may influence a particular person’s risk tolerance can include age, investment experience, financial goals, and income stability. Emotions and personality naturally contribute to risk tolerance, as well.
Someone with a higher tolerance for risk may lean heavily toward stocks and alternative assets like real estate. However, someone with a low risk tolerance will likely prefer bonds or cash. However, the personal balance between potential rewards and risk looks different for everyone.
Common Asset Allocation Models
Financial planners typically use three general portfolio models to allocate assets more practically. Each reflects a different level of risk tolerance.
Conservative portfolio
The goal of a conservative portfolio is to preserve capital and is recommended for investors with low risk tolerance and short time horizons. A typical allocation might look like: 50% bonds, 20% stocks, and 30% cash.
Balanced portfolio
This type of portfolio is designed to strike a comfortable balance between stability and growth. It’s also a solid fit for medium risk tolerance and mid-level time horizons. A typical allocation could shake out to: 50% stocks, 40% bonds, and 10% cash.
Aggressive portfolio
This type of portfolio maximizes long-term growth. It’s also best suited to those with a high tolerance for risk and a long time horizon to work with. A standard allocation might look a lot like: 80% stocks, 15% bonds, and 5% cash.
Monitoring and Rebalancing Your Portfolio
Ideal allocation of assets isn’t something you do just once. Market movements, changing financial goals, and life changes call for periodic review and rebalancing of your portfolio to ensure it’s still aligned with your goals and needs.
Success is all about building and maintaining a portfolio that works for you, and whether you need advice on refining your current allocation or assistance starting a new investment journey, MyStages is here to help. Contact us today to schedule a consultation.
