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Portfolio allocation is about reaching the right balance of investments. It is an ongoing process because it evolves around two important criteria: the time you plan to hold the investment, and your risk tolerance. Whether saving for a child’s college education or for retirement, what works best for you when you are in your 30’s will probably be different from what will work best when you are in your 60’s.
In its simplest form, asset allocation is divided between stocks, bonds and cash. Stocks, also called equities, typically represent ownership in a publicly traded company. They have the highest risk of any of the investment choices but also the highest potential for return. You buy them either individually or in the form of mutual funds, which are made up of many stocks. Bonds have a lower investment risk but the returns are also typically smaller. While bond value is subject to changes in the interest rate market, they do not go through the high swings that stocks can and do. Cash, either in a savings account, certificate of deposit or money market fund, is the safest investment but usually offers the lowest rate of return.
Length of Investment
The length of time you plan to hold an investment affects your portfolio allocation. For example, if you have a window of only a few years to finance a college education, you might feel better if most of your money was allocated to bonds or cash because there's less risk of losing money than with stocks. On the other hand, if you are in your 30’s and saving for retirement at 65, you might be willing to put the bulk of your money into higher-risk stocks and growth funds because you have enough time to wait out the ups and downs of the markets.
Your ability to mentally and emotionally handle the ups and downs of the market will help to define your risk tolerance. If you are willing to risk losing some or all of your investment for a potentially high return, then you have a high-risk tolerance. This means you are prepared to put a bigger share of your money into high-risk investments. If you prefer your investment choices to protect your money, then you are a low-risk investor and will most likely prefer to put most of your money into low-risk investments. Most investors fit somewhere in between.
Risk and Reward
It is important to understand the risk and reward relationship before making your allocation decisions. For instance, a low risk investment such as a savings account not only will have a low potential return, but the return might not even be high enough to keep up with inflation. On the other hand, you could lose money that you invest in stocks and bonds. But if you are willing to take some risk, you may be rewarded with higher returns.
Conventional wisdom used to recommend subtracting your age from 100 to calculate your asset allocation. If you are 30, for example, you would have 30 percent of your portfolio in cash and bonds and 70 percent in stocks, with the assumption that you had a lot of years to ride out the market’s ups and downs. When you turn 70, the ratio reverses. Today, with people living longer and staying healthier longer, many financial managers recommend a more aggressive philosophy where you would increase the percentage of risky investments.
- pie chart 2 image by chrisharvey from Fotolia.com