When investing money, one of the first decisions to be made is your asset allocation. Asset allocation is the division of your assets into different types of investments such as stock mutual funds, bonds, real estate or cash. In order to maximize the return on your portfolio it’s crucial to maintain a well-diversified asset allocation. According to many financial experts, asset allocation may be your single most important investment decision, more important than the specific investments or funds that you select.
There is no one size fits all; the right asset allocation is based on your unique situation which may change as your circumstances or perspective changes. Some major factors to consider include investment time horizon, the need for liquidity, risk tolerance, risks taken in other areas of your life and how much risk is required to achieve your goals.
Arriving at the appropriate asset allocation is largely a balance between risk and return. If you want or need a higher return you will have to assume a higher level of risk. If you have a long investment time horizon, you can take on more risk because you don’t need your money right away and you can ride out fluctuations in the market. However, if you have a short time horizon you should minimize your risk so your money will be readily available.
If you want to minimize risk, invest in fixed income investments such as money market accounts, certificate of deposits, high quality bonds or short term bond funds. If you are willing to take on more risk, with the expectation of getting higher returns, consider stock mutual funds. Generally, avoid investing money needed in the next five years into the stock market. However, the stock market is an excellent option for long term money.
Regardless of your situation, the best allocation is usually a combination of fixed income and stock mutual funds. With a diversified portfolio you can take advantage of higher returns found in the stock market while buffering your risk and meeting short term needs with fixed income investments.
Once your target asset allocation is set, rebalance on annual basis to stay on target. Rebalancing will automatically result in selling investments that are high and buying investments that are low. Avoid changing your target allocation based on emotional reactions to short term market fluctuations. Stick to your plan unless there are major changes in your circumstances.
If you are unsure where to start, a good rule of thumb is to subtract your age from 120 to arrive at the percentage you should invest in stock market. In the past it was customary to subtract from 100 but this has increased as life expectancies and the time one spends in retirement have increased. In the final analysis, select an asset allocation that meets your specific needs and gives you peace of mind.