Essentials of asset allocation
Published 7:33 pm Friday, July 16, 2010
In the wake of the financial markets meltdown in 2008 and 2009, it may seem brazen to remind investors of the principles of asset allocation because, frankly, even the most intelligently allocated portfolios ran into difficulties.
Yet, generally, it has been true that stocks and bonds move separately within a portfolio while cash or cash alternatives steady the balance, thus reducing portfolio risk and smoothing returns over time.
In the eyes of most market analysts, asset allocation principles remain sound and should not be abandoned in favor of more opportunistic ideas that might seem momentarily attractive.
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So, basically, time-tested asset allocation means dividing your investment portfolio among broad asset classes, including equities, fixed income and cash. Other classes may provide additional balance.
That is only the beginning, of course, because even if you determine what percentages of your portfolio to dedicate to equities, fixed income or cash, you’re still faced with multiple choices.
Investment possibilities within each category exist in great variety, and in order to complete an appropriate allocation of your assets, you’ll have to take the next step, which is diversification—the range of investments you actually make within each asset category—with the specifics probably dictated by your financial goals, your investment time horizon and your risk tolerance level.
Equities, or stocks, entail more risk than some other asset categories—but, historically, they have provided greater returns.
If you’re young and your goals can allow you to wait out market gyrations over time, you’ll probably want a high proportion of your portfolio in equities, both domestic and foreign.
If you’re approaching or already in retirement, you’ll no doubt want a much smaller percentage of your portfolio allocated to the riskiest investments and much more of it invested in fixed income instruments likely to provide steadier but lower returns, as well as cash or cash alternatives.
Your portfolio’s fixed income allocation, which may include domestic and foreign bonds, should help keep your risk level lower, especially in times of market volatility.
The cash or cash alternatives element—money market accounts or funds, certificates of deposit, or cash in a bank account—is likely to grow even less, but these funds are easily accessed and add to portfolio stability.
Keep in mind that asset allocation always involves trade-offs.
Higher return potential equals greater risk; lesser risk almost always means lower returns. The best portfolio ideas involve an astute allocation of assets, intelligently diversified.
There is no assurance that any investment strategy will be successful. Investing involves risk and investors may incur a profit or a loss.
Asset allocation and diversification do not ensure a profit or protect against a loss. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. International investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility.