Investment professionals can't say it enough—diversify, diversify, diversify—and with good reason. Diversification is the driving force behind the investment strategy known as asset allocation.
Investing in more than one type of investment, or asset class, can help lessen the negative impact on your portfolio during a market downturn in any one asset class, while potentially increasing your chances of reaching your overall financial goals.
Asset allocation is not just about multiple investments—it's also about properly allocating your money among asset classes that best match your objective, risk tolerance level, and time horizon.
Asset classes are generally divided into three major classes: stocks, bonds, and cash. Here's a look at how they compare to one another:
Stocks—represent ownership in domestic or foreign companies. Stocks usually carry a higher level of market risk than the other classes, however, they also have potential for greater returns over the long term.1Inflation risk—the risk that your investment will not keep pace with the rising costs of goods and services—is lower with stocks, as they have historically outperformed the rate of inflation over the long term.
Bonds—are loans or debt to a corporation or government. Bonds generally carry less market risk than stocks. However, income investments carry interest rate risk, or the risk that the investment's value will decrease as interest rates increase. Inflation risk is higher for bonds than stocks because their returns over the long term have been historically lower. They also carry credit risk and business risk.
Cash—refers to any investment that is readily accessible or liquid, such as money market funds. Like bonds, cash instruments carry low market risk, but because of lower returns, they may not outpace inflation.
1 Past performance is no guarantee of future results. Investment return and principal value will fluctuate so that upon redemption, shares may be worth more or less than their original cost
Taking Turns at the Top
There are many subcategories within the three major asset classes. For example, small-cap, mid-cap, and large-cap are segments of the stock asset class, and even those can be drilled down further into growth and value segments. To get an idea of how key asset classes have performed in the past 20 years, check out Taking Turns at the Top.
Once you understand the potential risks and rewards associated with each asset class, you can better choose a mix of classes to help meet your investment goals. These choices are not easy, especially with thousands of mutual funds in the marketplace and even more individual investments offered these days. Allocating your assets based on performance alone is not generally recommended because today's stellar performers may be tomorrow's underachievers.
Your risk tolerance level, age, investment time horizon, and investment objectives are all important considerations when choosing the right mix of investments. A registered investment professional can assist you in this process.
Consider these examples to help decide how to diversify. If you have:
a short-term time horizon (only a few years to invest) and a low risk tolerance, you may be able to achieve your goal by investing in a large percentage of cash and bonds or bond funds and a small percentage in stocks or stock funds.
an intermediate-term horizon (you're about halfway to your goal date) and you're willing to accept a moderate level of risk, you might consider allocating about half or more of your assets in stocks or stock funds and the rest in cash and bond instruments.
a long-term time horizon (you have a longer period of time to invest) and a high tolerance for risk, your allocation could include a large percentage of stock investments and a small percentage of cash and fixed-income securities.
Asset allocation is not just a one-time task. It's important to regularly monitor your investments to make sure your original allocation has not shifted. For example, stocks or stock funds that significantly outperform other asset classes can cause them to carry more weight in your portfolio. So, if you prefer a smaller allocation in stocks, you'll need to adjust your asset allocation.
Additionally, as your time horizon shortens, you may doubt your financial ability to meet your goals or, conversely, you may require a less aggressive allocation because you're nearing your goal. Again, it makes sense to meet with your registered investment professional to take a fresh look at your asset allocation plan. Of course, any portfolio change should be carefully considered, and we recommend that you discuss it with your tax advisor.
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