The process of spreading your investments across the major asset classes of stocks, bonds and cash is called asset allocation.
According to most financial experts, your asset allocation decisions are the most important determinant of your investment returns. Trying to "time" the market on the way up and down is a much riskier way to boost returns.
Asset allocation helps you to diversify your investments. Diversification results in either a higher rate of return for a given amount of risk, or a lower amount of risk for a given rate of return.
Asset allocation is a fairly simple process. After you make your initial allocation, you generally only need to rebalance your portfolio from time to time to achieve your financial goals. Financial planners often suggest that you rebalance once a year or so, or after a major life event such as a birth or death in the family. Rebalancing also lets you take advantage of changes in interest rates and investment valuations to adjust the composition of your portfolio.
To begin the asset allocation process, you should have some idea of the following: Risk tolerance.Risk tolerance is your willingness to accept risk in exchange for a higher rate of return. Investors may have a low or high risk tolerance. In many cases, their risk tolerance falls somewhere in between. We'll see later how your risk tolerance affects the types of investments you make.
Investment horizon.Investment horizon is the length of time, measured in years, that you have to save before you need to start using some or all of your investment funds. The longer you can invest, the larger your investment is likely to grow to, particularly if you invest in assets that have higher volatility.
Investment categories. Several categories of investments exist within each asset class. For example, bonds include corporate, government and municipal bond categories. Investment categories often have unique risks that require a better understanding of each investment's characteristics.
Portfolio approach to investing. If you manage your investments as a portfolio, you stand to benefit the most from diversification. When you diversify across asset classes, you reduce the volatility in returns that may occur if you, say, invest entirely in growth stocks.
Risk-return trade-off. Over longer periods, stocks have historically earned a higher rate of return than bonds or cash. However, stocks also exhibit more volatility in year-to-year returns. This phenomenon of higher returns associated with greater risks is called the risk-return trade-off.
Tax-advantaged accounts. If you use a tax-advantaged account such as an IRA or 401(k) to invest, you defer income taxes until you begin to take out the money. As a result, a tax-advantaged account benefits more from compounding than a taxable account. Tax-advantaged accounts are aimed at encouraging savings for retirement or college. As a result, you will likely owe an early-withdrawal penalty if you take money out of a tax-advantaged account too soon.
In making well-informed asset allocation decisions, you also need to make reasonable assumptions about:
Financial goals. How much you want to save -- and in what time frame you want to save it -- is an example of a financial goal. Most of us have several financial goals. These goals often include retirement, buying a home or paying for a child's college education.
Contributions. Your contributions -- how much and how often -- have some bearing on your asset allocation decisions. For example, if you're not contributing fast enough to save for retirement, you're likely to need to invest more aggressively in order to achieve your goal.
Life expectancy. While the average lifespan in the U.S. for men and women is somewhere in the low- to mid-70s, many financial planners suggest you plan to live to age 80 or 85. As you get older, your chances to live to a ripe age increase. That means stretching your investment portfolio to last longer.
Expectations for interest rates, inflation and returns. Be realistic about your expectations for investment returns. The stock market salad days of 20% annual returns in the late-1990s are over, say many financial experts. Single-digit returns are a more realistic planning assumption. Your outlook for inflation and interest rates will also influence your asset allocation decisions.
An important step in making your asset allocation decisions is to measure your risk tolerance. Next, we look at how to do that.