Why do I need asset allocation?
Weigh risk and returns
Risk and return go hand in hand. You can’t have one without the other. Generally, the more risk you take on, the higher the potential returns.
The challenge is to find the right balance between investments risky enough to provide some growth and those conservative enough to maintain a good night’s sleep. How you choose to spread your money among different investment types is called asset allocation.
While diversification is about investing your dollars in more than one place, asset allocation involves larger categories of investment types, known as asset classes.
Stocks are an asset class; so are bonds. In different markets, stocks and bonds may act differently. Investing in both can help lower the risk of everything getting hit at the same time and to the same degree. This can help reduce the effects of volatility.
Keep an objective in mind
Mutual funds can help take a lot of the guesswork out of asset allocation. A fund can represent an asset class or even an allocated portfolio. They also come with their own objectives. Are you focused on growth at any cost? There’s a fund for that. More concerned with keeping what you already have? There’s a fund for that too.
As an example, here are some categories typically found in retirement investing plans, sorted by relative risk:
Growth funds primarily invest in stocks of growing companies with the potential for above-average gains. The prices of these stocks may have higher highs and lower lows from day to day.
Growth and income funds typically invest in stocks of more established companies that have good earnings prospects and pay dividends, which is a form of profit-sharing that can provide additional income. This income helps cushion those extreme market ups and downs.
Equity income funds invest primarily in dividend stocks as well as bonds. These funds tend to produce lower returns compared to growth funds when the stock market is on the rise. But the income that comes from investing in solid companies can soften the impact when the market falls.
Balanced funds typically invest in a combination of stocks, bonds and cash to balance the goals of growth, preservation and income.
Bond funds invest primarily in bonds or short-term, cash-like investments and are designed to provide regular income from the interest that bonds pay. Bond funds can help investors ride out stock market downturns but tend to have lower returns.
Find your fit
Your work as an investor is to strike a balance that makes sense for you. To do this, start with the number of years you plan to be invested.
Generally, the more time you have, the more risk you can afford to take. When you are young, with plenty of time on your side, you may choose to put a larger share of your money in investments with a high potential for growth, like stocks. As you near retirement, you might move money into conservative investments, like bonds. These investments may grow more slowly, but the money is more likely to be there when it’s needed. You can work with a financial professional to create an allocation matched to your unique needs and goals.
Set a rebalancing schedule
Once your asset allocation is set, all that’s left is keeping it that way. As investments grow or fall in value, allocations can shift over time. If one portion of your portfolio is outperforming, it will grow more quickly than the others and upset your overall mix.
The easy solution is to check in yearly to rebalance your investments. Rebalancing generally involves selling investments that have performed well and buying more of what has not done well, with an aim to bring your allocation back to match your individual needs and goals. If it seems counterintuitive to take money from an asset that’s up and move it to one that’s down, think of it as realizing profits in one area to buy possible bargains in another.
Consider investments that can do the work for you
If you want an even easier way to get allocated, there are mutual funds that can do the work for you. These “funds of funds” invest in a variety of mutual funds to achieve a certain asset allocation. One popular type is the target date fund, which you choose based on the year you plan to reach your goal. It’s managed so the asset allocation changes over time — going for growth initially and becoming more conservative as the target date nears. You could also use target date funds to invest for a goal with a set date, from paying for college to retiring.