In today's complex financial markets, you can select from an impressive array of investment vehicles. Each investment also carries some risks, making it important to choose wisely if you are selecting just one.
The good news is that there's no rule that says you must stick with only a single type of investment. In fact, you can potentially lower your investment risk and help increase your chances of meeting your investment goals by practicing "asset allocation."
What Is Asset Allocation?
Asset allocation refers to the way in which you weight investments in your portfolio in order to try to meet a specific objective. For instance, if your goal is to pursue growth (and you're willing to take on market risk in order to do so), you may decide to place 20% of your assets in bonds and 80% in stocks.
The asset classes you choose, and how you weight your investment in each, will probably hinge on your investment time frame and how that matches with the risks and rewards of each asset class.
Focus On The Three Primary Asset Classes: Stocks, Bonds, and Money Markets
Here's a closer look at the risk and reward levels of the major asset classes:
Well known for fluctuating frequently in value, stocks carry a high level of market risk (the risk that your investments' value will decrease after you purchase them) over the short term. However, stocks have historically earned higher returns than other asset classes over the long term, although past performance is no predictor of future results. Stocks have also outpaced inflation -- the rising prices of goods and services -- at the highest rate through the years.
In general, these securities have less severe short-term price fluctuations than stocks, and therefore offer lower market risk. On the other hand, their overall inflation risk tends to be higher than that of stocks, as their long-term return potential is also lower.
Money Market Instruments
Among the most stable of all asset classes in terms of returns, money market instruments carry relatively low market risk. At the same time, these securities lack the potential to outpace inflation by as wide a margin through the years as stocks.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Different investments offer different levels of potential return and market risk. Unlike stocks and corporate bonds, government T-bills are guaranteed as to principal and interest, although money market funds that invest in them are not. Past performance is not indicative of future results.
*Source: ChartSource®, DST Systems Inc. For the period from January 1, 1986, through December 31, 2017. Large-cap stocks are represented by the S&P 500 index. Midcap stocks are represented by a composite of the CRSP 3d-5th deciles and the S&P 400 index. Small-cap stocks are represented by a composite of the CRSP 6th-10th deciles and the S&P 600 index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond index. Cash is represented by a composite of the yields of 3-month Treasury bills, published by the Federal Reserve, and the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index. Foreign stocks are represented by the MSCI EAFE index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Copyright © 2018, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. (CS000136)
Diversification: The Basis Of Asset Allocation
Before exploring just how you can put an asset allocation strategy to work to help you meet your investment goals, you should first understand how diversification -- the process of helping reduce risk by investing in several different types of individual funds or securities -- works hand in hand with asset allocation.
When you diversify your investments among more than one security, you help reduce what is known as "single-security risk," or the risk that your investment will fluctuate widely in value with the price of one holding. Diversifying among several asset classes may increase the chance that if and when the return of one investment is falling, the potential return of another in your portfolio may be rising (though there are no guarantees and the total value of your portfolio may decline).
For example, in 2017, domestic large-company stocks gained 21.8%, while foreign developed market stocks gained 25.6%.** (Keep in mind that past performance cannot guarantee future results.)
**Source: ChartSource, DST Systems, Inc. Domestic large-company stocks are represented by annualized total returns of the S&P 500, an unmanaged index generally considered representative of the U.S. stock market. Foreign developed market stocks are represented by the MSCI EAFE index. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.
Asset Allocation Can Work
Asset allocation tends to vary with your life stage. For instance, at age 25, you may decide to invest with the goal of retiring in comfort within 40 years. Most likely, your investment goal is to achieve as much growth as possible -- growth that will outpace inflation substantially.
In aiming to reach this goal, depending on your individual risk tolerance, you may allocate 70% of your assets into aggressive growth stocks, 20% into bonds, and 10% into money market instruments. You have years to ride out the wide fluctuations that come with stocks, but at the same time, you help manage your risk with your bond and money market holdings.
Because your goals and circumstances are unique, you should talk with a financial professional who can help you tailor an allocation strategy for your needs. Generally, your asset allocation will change with your life, your lifestyle, and your investment goals. If you have been investing aggressively for retirement for more than 20 years and are now less than 10 years from retiring, protecting what your investment may have earned from market ups and downs may become more important. In this case, you may want to gradually shift some of your stock allocation into your bond and money market holdings. Keep in mind, however, that many financial experts recommend that stocks be considered for every suitable portfolio to maintain growth potential.
Asset Allocation: Learn The Strategy For Boosting Potential Returns
Asset allocation is a simple concept, yet vital to long-term investment success. In fact, a landmark study cited in Financial Analysts Journal showed that 91.5% of the average total returns earned by pension plans over a 10-year period (from 1977 to 1987) was the result of the plans' asset allocation decisions.***
***Source: "Determinants of Portfolio Performance II: Does Asset Allocation Policy Explain 40, 49, or 100 Percent of Performance?" Financial Analyst's Journal, January/February 2000.
For many individual investors, the asset allocation decision amounts to choosing what types of mutual funds to invest in and the amount to invest in each type of fund. Others may want to add individual securities to this mix after exploring their investment options.
Regardless of the asset allocation strategy you choose and the investments you select, keep in mind that a well-crafted plan of action over the long term can help you weather all sorts of changing market conditions as you aim to meet your investment goal(s). Please note, however, that asset allocation does not guarantee a profit or protect against a loss.
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