Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing. Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio. Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds. An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.
There is a trade-off between risk and return. Generally, if you want a higher return you need to assume a higher level of risk. Investment risk comes in many different forms with the most common being stock market risk. Historically, over long periods of time, the stock market has out-performed most other investments. However, in the short term it can be extremely volatile, including years with negative returns. In the extreme case you could lose your entire investment in an individual stock. To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.
On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations. Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.
Additionally, bonds and bond funds are subject to interest rate risk and default risk. If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease. To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss. Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption. Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.
Many investors don’t consider inflation risk. This results from taking too little risk with a conservative portfolio containing little or no stock. Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative. This is compounded if inflation rates rise significantly. Consider increasing your allocation in the stock market to hedge against inflation risk.
In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.