Investing, particularly in the stock market, involves risk. It is unpredictable and volatile. For the average investor, trying to time the market is not feasible. Instead, you can manage risk with the right asset allocation.
What is asset allocation?
“Asset allocation” means dividing your money among asset classes — the types of things you can invest money in — based on your financial goals.
You want to do this because:
- It keeps money for short-term goals, immediate cash needs, and emergencies from being at risk.
- It lets you invest money for long-term goals in assets that historically provided the greatest return and kept pace with inflation.
- It positions your long-term money to bounce back after a correction or bear market.
- You reduce your risk as you get closer to the time you need the money (for example, retirement or college).
- Your risk tolerance matters.
You can invest among three major assets classes: stocks, bonds, and cash. Each varies in its potential risk and returns.
Stocks: Stocks are pieces of ownership in a company. Of the three main asset categories, stocks have historically provided the greatest returns for long-term goals. However, they are also the riskiest and most volatile, which makes them unsuitable for short-term goals.
Bonds: A bond represents a loan you, as an investor, make to the bond issuer. The issuer can be a corporation; federal, state or local government; or a government agency. Bonds have historically been less volatile than stocks, but the historical returns have been more modest. Investors in bonds typically want stable, albeit lower, returns in return for less risk.
Important note: Some bonds classified as “high yield” or “junk bonds” based on their ratings could provide returns equivalent to stocks, but also carry a high risk.
Cash: Cash and cash equivalents have the least amount of risk but provide the lowest return. This class includes checking and savings accounts, certificates of deposit (CDs), money-market accounts (MMAs), money-market funds, and Treasury Bills. You can generally expect your principal to be safe in these instruments, but the return may not keep pace with inflation.
Alternatives: Other asset classes, such as real estate, precious metals, and commodities, are less common investments for things like retirement accounts and college savings plans. But they could be sound options, with varying levels of risk and potential reward, if you want to diversify further.
Asset classes are not directly correlated
Historically, the major asset classes don’t gain and lose value under the same circumstances.
- When the stock market is extremely volatile, in a correction, or in a bear market, investors looking for safety tend to move money to bonds, increasing bond prices. While your stocks may lose value, your bonds would gain value.
- When interest rates are low, bonds are not as appealing, so investors seeking a higher return tend to move money to stocks, raising stock prices. This could decrease the value of your bonds, but increase the value of your stocks.
A mix of assets that aren’t directly correlated in your portfolio can reduce the overall risk.
Your ideal asset allocation depends a lot on your time horizon, the amount of time before you plan to withdraw funds from your investment accounts.
Short-term (less than three years): Don’t put money you need for short-term savings and immediate expenses at risk. You don’t want to find yourself short of cash when you need it — for a down payment on a new home, a new car, tuition payments, an emergency fund, or a life-changing event that increases your need for cash. The priority for these funds is to make sure the money you put away is there and accessible when you need it, so cash or a cash equivalent is suitable.
Long-term (more than 10 years): If your investable funds are for goals more than 10 years away, such as a 401(k) or IRA plan for retirement or a 529 plan for your kid’s higher education, the largest chunk of your investment portfolio should be in stocks. Your asset allocation should only have a small percentage in bonds and cash. Over the long term, stocks tend to yield the best return. And your long time horizon lets you ride out any volatility and bear markets.
Mid-term (three to 10 years): It gets a little more complicated when your goal is neither long-term nor short-term, but is somewhere in between. Putting it all in cash will provide a minimal return. But there may not be enough time to recover from a market correction if you’re mostly invested in stocks. You’ll need to balance the risk with a portfolio that has no more than about 50% in stocks — even less as you get closer to the time you need the money.
How to determine the right asset allocation for your goals
Your financial institution also likely offers an asset-allocation calculator to help you determine the right mix of stocks, bonds, and cash based on your goals, financial condition, time horizon, and risk tolerance.
Understanding your risk tolerance is important. Jumping in and out of the market based on emotions will not lead to success. You need to know how much volatility and loss you can tolerate so you won’t deviate from your plan.
When should you adjust your asset allocation?
You should adjust your asset allocation in a few cases:
Change in time horizon: As you get closer to reaching your goals, your time horizon changes. Over time, your long-term goals will become mid-term goals, and eventually short-term goals. As your time horizon changes, you will need to adjust your asset allocation. You don’t want to be in 90% stocks three years away from your retirement date.
Change to your financial situation: As your financial needs change, you may need to adjust your asset allocation. For example, if you lose your job or have unexpected medical bills, you may need more cash available.
Change in risk tolerance: Is the stock market volatility keeping you awake at night? Are you constantly looking at your accounts? Maybe it’s time to reassess your risk tolerance. If you realize you don’t have the appetite for risk you had before, you can adjust your asset allocation to include fewer stocks. This does not mean panic sell or try to time the market. It just means finding the right mix of stocks, bonds, and cash so you can stay the course.
Rebalancing your portfolio
In addition to changing your asset allocation in case of changes to your financial needs, you should periodically review your investments and make sure your asset allocation remains what you need. Over time, one asset class might outperform others and become out of balance with the original allocation.
To maintain the balance, you can sell the assets from the overperforming asset class and buy more of the underperforming asset class.
Another method for rebalancing is to add funds to the underperforming asset class to maintain the planned allocation.
This may seem counterintuitive. Why would you want to sell assets that are doing so well and increase the ones that aren’t? The answer is easy: It forces you to buy low and sell high. The strategy here is not to try to time the market, but to manage the risk and uncertainty of investing.
When should you rebalance?
You can rebalance your portfolio yearly, quarterly, or monthly. The exact time period is not as important as making sure you’re disciplined and consistently rebalancing.
You can also rebalance based on when your asset allocation model deviates by a certain percentage.
For example, say you want to maintain a balance of 60% stocks, 30% bonds, and 10% cash. Your trigger to rebalance can be when an asset class deviates by more than 10 points from the original allocation. In this scenario, you would rebalance if the stock portion of your portfolio grows to more than 70%.
Diversification is just as important!
Having the right asset allocation won’t reduce your risk if you only have one stock and one bond. You need to also diversify your investments within each asset class. Hold a variety of companies and sectors within each asset class to limit the chance that any negative event in one company or business sector can gut your investment.
One of the best ways to diversify is to invest using mutual funds or exchange-traded funds (ETFs). Each fund will invest in a variety of companies based on the fund’s objectives, so you don’t have to choose assets individually.
Target-date funds simplify asset allocation even further by not only investing in a variety of companies, but also maintaining an asset-allocation based on the date you need the funds. You simply pick a fund with a target date that coincides with the date you plan to retire, pay tuition, or whatever your goal is.
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