Investment Asset Allocation 101
May 31, 2011
Asset allocation is an important concept to understand in investing. However, like so many things related to money, determining your own asset allocation is a personal exercise, and one that doesn’t mean the same thing for every person. Figuring out your own asset allocation means considering your investing goals, and your risk tolerance, in an effort to decide what mix of assets is likely to benefit you the most.
Considerations When Allocating Assets
As you allocate your investment assets, you need to consider diversification. Diversification can help you take advantage of different aspects of some investments, while providing you a degree of protection from risk. The point of asset allocation is to diversify your portfolio in such a way that allows you to enjoy appropriate growth while at the same time reducing — to some degree — your exposure to losses. Here are some things to take into account as you diversify:
Market Cap: Capitalization is a way to measure the size of a company you’re evaluating. The market capitalization of a publicly traded company is determined by the of value of the share price times the number of outstanding shares. Large cap companies usually have values of more than $8 billion. Mid cap companies have a capitalization of between $1 and $8 billion. Small cap stocks are those with a value of less than $1 billion. There are also micro caps with even tinier values.
In general, large cap investments are considered more stable, while smaller cap stocks exhibit the potential for larger growth. You can allocate your assets to include a mix of large and small caps, or use mid caps for a mix of stability and some growth possibility.
Growth: Different investments come with different growth possibilities. The term “value stock” indicates companies whose share price is low compared to it’s balance sheet value, profits, or cash flow. When you buy a value stock you’re betting that based on the fundamentals the price should go up. You may not see an enormous amount of fast growth but the idea is that over time the value of these investments should increase.
Companies that are in markets or industries with alot of opportunity for relatively quick growth or expansion are known as growth stocks. While these can gain in value more quickly they are also more prone to sudden losses. Including growth investments makes your portfolio more volatile but can also give it a boost.
Capital preservation investments, such as bonds and some cash products are designed to help you keep pace with inflation. These are generally considered less risky. Your portfolio won’t grow enough if all you have are capital preservation investments. However, they add a safety net to the portfolio.
Sector and Industry: Consider what kind of investment you are making in terms of industry. If the tech sector is struggling, health products might be doing well. Mixing it up so that you aren’t over-exposed in one sector or industry can help you limit losses if one section of your portfolio tanks.
Asset class: Consider asset class as well. This is paying attention to such things as commodities, real estate, stocks, bonds, cash and currencies. While some asset classes might not be attractive to you, having some diversity across asset classes — even if it is just a stock, bond, cash mix — can be helpful.
Domestic vs Foreign: You can also use asset allocation to diversify into international investments. Some foreign investments, such as bonds in emerging market countries, can add growth to your portfolio. In some cases, there are foreign companies with just as much staying power as venerable U.S. companies; these can add stability to your portfolio.
Deciding on Your Own Asset Allocation
Once you have an idea of the possibilities, it’s time to decide on your own asset allocation. Your asset allocation will change over time, depending on your goals, and your financial risk tolerance.
In the case of retirement, experts recommend that you invest in riskier assets when you are young, since you will see faster growth, and still have time to overcome mistakes. As you get closer to retirement, though, your asset allocation should shift so that your investments are less risky. Many people shift to cash, bonds and low yield dividend paying stocks as they age, since these are investments that provide income, and are considered stable. You might retain some riskier investments in your portfolio, but they would not be the bulk.
There are rules about subtracting your age from 100 or from 120 and using that as a guide for how much you should have in stocks. (I’m 31, so following the 100 rule I should have 69% of my portfolio in stocks.) But, really, it depends on what you’re comfortable with, and how much of hit your finances can take. When in doubt, you can consider the following approximate ideas for asset allocation, depending on when you think you’ll need your money:
Next Year: Cash. Money should be in something safe and fairly accessible. You should have some in other investments, but money you plan on using within the next year should be in cash.
2-7 Years: Income producing assets considered relatively safe, such as high yield CDs and bonds. If your needs are on the far end, mixing in some dividend aristocrats might be worth it.
More than 7 Years: Money you won’t need for at least 7 years is likely to do OK in riskier investments, including stocks. Sometimes, the long term can be a good place for investments that are likely to grow over time, such as real estate.
Before you invest in anything, though, it’s a good idea to do your research, and possibly speak with a professional. All investment comes with the risk of loss, so you should be prepared for that possibility and only put money at risk that you can afford to lose.
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