Stocks, bonds, cash equivalents—your investment portfolio is composed of different asset categories. But a 25-year-old’s portfolio looks markedly different from that of a 65-year-old—or at least it should. As you age and move closer to retirement, your asset allocation should reflect your desire to preserve capital, which manifests itself as a decreased tolerance for risk. Read on to learn more about asset allocation strategies. A solid understanding of asset allocation models will help you protect your money, thus safeguarding your retirement.
Understanding Asset Categories
Before we explore asset allocation strategies, it’s important to understand the different asset categories, including stocks, bonds, and cash equivalents. Armed with a solid understanding of the distinct characteristics of these different assets, you will then be better prepared to allocate these assets based on your investment goals.
Stocks are shares of a company. Investors in stocks are generally rewarded with positive long-term returns, but stocks are notoriously volatile. The value of a stock may go up and down within the span of a few days, but over a long timeframe (say, 10 years), stocks generally go up. As such, they are not short-term investments.
Bonds are loans to the government or a company that pay back a fixed rate of return. Bonds are less volatile than stocks, but carry lesser returns. High-yield (“junk”) bonds have the potential for a higher return (like stocks), but also carry more risk. Investing in bonds is a more conservative approach than investing in stocks.
Cash, and cash equivalents like savings deposits, certificates of deposits (CDs), treasury bills, and money market accounts are the safest form of investment. But with low risk comes low returns. The primary concerns with holding most of your portfolio in cash equivalents is that inflation will outpace returns.
Mutual funds pool money from different investors to then invest in collections of stocks and bonds. When you purchase a mutual fund, you are buying a share of the portfolio’s value.
ETFs, or exchange-traded funds, are baskets of securities that track a specific index. They are traded on stock exchanges.
What about alternative investments? Some brokers might tout real estate and private equity as the “next big thing.” However, these investments are risky and are often illiquid (meaning that you would not have easy access to the cash value of your investments). Thus, speculative investments are not suitable for older investors who wish to preserve their principal as they approach retirement.
“A Bird in the Hand is Worth Two in the Bush”?: Risk Tolerance and Time Horizon
Your asset allocation strategy depends on your time horizon and risk tolerance. What do these terms mean?
Time horizon refers to the length of time before you would like to access your investments. If you are 30 years old and would like to retire at age 67, the time horizon for your retirement portfolio would be 37 years and it would be prudent to “play the long game.” That might look like investing mostly in stocks for the time being, and then shifting your asset allocation to include more conservative assets, like bonds, as you get closer and closer to retirement. If you have a 529 college savings plan and your child just turned two, you have a pretty long time horizon before you have to cash out the plan and you might want to take on a bit more risk. On the other hand, if your college-student-to-be is sixteen, your asset allocation should be more conservative, since you want to preserve the principal so that the money can go towards college tuition.
If you are concerned about choosing the correct investment for your time horizon, you might consider lifecycle funds. Lifecycle funds, also known as “target date funds,” are a type of investment that specifies your time horizon. They are named accordingly, such as “Lifecycle 2045 Fund.”
Risk tolerance refers to how much risk you as an investor are willing to take on. Younger investors, who have time to weather the storms that may befall the stock market over a period of several decades, have a higher tolerance for risk than older investors, who seek to preserve their capital. A high-net-worth individual has a higher risk tolerance than someone who is struggling to pay their bills because if the value of their investments decline, they won’t be thrown into financial ruin.
You are likely familiar with the old adage “a bird in the hand is worth two in the bush.” Younger investors who have more time to recoup potential losses may feel free to relinquish their one “bird in the hand” to go after the “two in the bush.” On the other hand, older investors should take a more conservative approach, and thus should strongly consider holding onto their “one in the hand.” As you age, or as your risk tolerance or financial situations changes, you should adjust your asset allocation accordingly. Time horizon and risk tolerance are intrinsically linked and, as such, investors should carefully consider these factors when evaluating their asset allocation strategy.
“No Pain, No Gain”?: Risk versus Reward
No matter what anyone tries to tell you, all investments involve some degree of risk. The challenge is to balance the risks and the rewards of investing. Choosing the correct asset allocation for your time horizon and risk tolerance is one way to try to reduce your risk while maximizing your returns.
Historically, stocks, bonds, and cash equivalents have not all moved up or down at the same time. If stocks go down, bonds may still be steady or may even go up. Thus, if you diversify your portfolio by choosing a mix of different assets, you will spread your risk around, thus giving you the best chance to protect your portfolio.
Asset allocation is part of a larger strategy called diversification, in which you invest in such a way as to minimize risks while trying to maximize returns. You need to diversify between asset categories and within asset categories. A diverse portfolio might include both stocks and bonds, which would be diversifying between asset categories, but if you are only holding four or five stocks, you would not be diversifying within asset categories. Twelve stocks would be more appropriate.
Once you have a sufficiently diverse portfolio, you want to make sure that your asset allocations remain consistent with your goals. If you originally were invested in 60% stocks, and the value of the stocks grew such that your portfolio became 75% stocks, it might be time to rebalance, such as by selling some stocks or buying more of other assets to bring the percentages back in line with your original goals. This process typically happens once a year. It could also be based on percentages, but either way, it should be relatively infrequent.
Calculating Your Asset Allocation
Your asset allocation model must match your financial goal. Asset allocation is considered by many financial professionals to be the most important decision you will make when it comes to investing. How do you calculate the proper asset allocation for your needs?
CNN Money reports that the traditional rule of thumb is to subtract your age from 100, and that’s how much you should put into stocks. For example, a 30-year-old should have 70% of their portfolio in bonds. As people live longer, however, the rule has changed. The updated rule of thumb states that you should subtract your age from 110 or 120. In that case, a 30-year-old might invest 80-90% of their portfolio in stocks. They would incur more risk, but they would also have the potential to reap larger returns, which could serve them well in the future if they live past the average American lifespan.
There are online tools that can help you calculate the proper asset allocation for your needs. For example, the Iowa Public Employees Retirement System (www.ipers.org) offers one such calculator. Your financial advisor or broker can also be a resource, but make sure you investigate their reputation on BrokerCheck or the SEC’s IAPD database, and understand that they may be biased in favor of investment products that could serve their interests.
If you believe that your broker may have recommended an unsuitable asset allocation strategy based on your investment goals, risk tolerance, and time horizon, don’t hesitate to contact a securities attorney to learn about your options for recovery. Call (877) 238-4175 or email email@example.com for your free case consultation with the securities attorneys of Fitapelli Kurta.