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Asset Allocation Basics

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Difference Between Stocks and Bonds

The theory behind diversification, or asset allocation, is to spread your investments across different asset classes to help protect your portfolio from downturns in any one asset. Diversification is a defensive strategy – it is meant to protect your portfolio during market downturns and to reduce your portfolio’s volatility.

Your asset allocation strategy will depend on your risk tolerance, return needs, and time horizon for investing. While each person’s asset allocation strategy will be unique, you should consider these tips:

To moderate your portfolio’s risk, invest in both stocks and bonds. Stocks tend to have a low positive correlation with corporate and government bonds, meaning that on average, movements in stock prices will only moderately match movements in bond prices. Thus, owning both reduces your portfolio’s risk.

With a long time horizon, you can increase your allocation to stocks. By staying in the market through different market cycles, you reduce the risk that volatility will adversely affect your equity performance. Those with a time horizon of less than five years should not be invested in stocks. Look at cash and bonds for those short-term needs.

Diversify within as well as among investment classes. For instance, in the stock category, consider value and growth stocks, small- and large-capitalization stocks, and international stocks. Bonds could include long-term bonds, intermediate-term bonds, high-quality bonds, lower-quality bonds, Treasury securities, municipal bonds, and international bonds.

Make sure you have reasonable return expectations for various investment categories. Basing your investment program on return estimates that are too high could cause you to increase the risk in your portfolio in an attempt to obtain higher returns.

Once you develop an asset allocation strategy, rebalance it at least annually. Since your strategy is designed to provide a stable risk exposure, you need to periodically rebalance so your allocation does not get out of line.

Make sure you have enough cash to handle short-term needs. That way, you won’t have to sell investments at an inappropriate time, such as immediately following a market downturn.

Evaluate new investments carefully, ensuring they add diversification benefits to your portfolio.

Don’t keep adding similar investments, such as several stocks in the same industry. Not only does this not add much in the way of diversification, but it makes your portfolio more difficult to monitor.

Avoid following the market too closely. Your asset allocation strategy is designed to guide your portfolio’s long-term makeup. Don’t rethink that strategy simply as a result of a market downturn.

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