Asset allocation is a key part of investing. It helps you avoid concentrating too much risk in one or more assets. However, over time, your percentages can shift away from the optimum, especially when certain investment categories perform better than others.
Your asset allocation should be based on your risk tolerance and how soon you’ll need your money. Stocks offer the highest return potential, while cash and cash equivalents have the lowest risk.
Diversification
As the saying goes, “Don’t put all your eggs in one basket.” Diversification is a key principle of successful investing. It involves spreading your investment portfolio among different asset classes and geographic regions to minimize risk. It is also important to diversify within each asset class. For example, invest in different sector funds to minimize the impact of declining stocks in one sector.
Investors must consider their time horizon when selecting an asset allocation. Those with a longer time horizon may feel comfortable taking more risks, while those who are close to retirement will want to reduce their exposure.
The best way to reduce the impact of market volatility is by combining low-cost, diversified index funds with target date funds and robo-advisors. These services offer easy ways to create a diversified portfolio, and they will automatically rebalance your investments. This reduces the need to manually rebalance your investments and saves you time and money. Additionally, it increases the chances of achieving your financial goals.
Time horizon
Whether you’re saving for retirement or a vacation, your time horizon will affect how much risk you’re willing to take. In general, longer investment horizons are associated with a higher tolerance for risk because investors will have more time to recoup losses from a market decline.
However, if you’re investing for a short-term goal, a market drop can derail your plans and leave you without the money you need to achieve your financial goals. For this reason, it’s usually best to stick with low-risk investments like savings or money market accounts and CDs when you’re planning for a short investment horizon.
There are many ways to diversify your portfolio, including by choosing a balanced mutual fund or robo-advisor that automatically tailors your asset allocation based on your investing horizon and risk tolerance. If you want to be more hands-on, though, you can try creating your own model with an online calculator or by consulting a financial professional.
Risk tolerance
Determining your risk tolerance and creating a portfolio that aligns with your goals within a realistic time horizon is a key factor in reaching those goals. Your risk tolerance is the amount of volatility and losses you can stomach while investing for your future.
Investors with a low risk tolerance are comfortable with the steady returns of bonds or cash but are not able to tolerate market fluctuations. Investors with a high risk tolerance are comfortable losing money in the short term and expect higher returns in the long term.
For example, a young investor may invest in more stocks to generate growth, while an older investor may put more money into bonds and cash to produce consistent income. However, investors should remember that the market’s short-term swings can be highly unpredictable. Historically, the stock market has delivered greater returns than bonds and cash, but these investments have also had larger ups and downs. A financial advisor can help you determine your risk tolerance and create a balanced portfolio.
Rebalancing
Rebalancing is a technique that helps investors maintain their investment portfolios at targeted levels. This is done by periodically selling investments in asset classes that have strayed from their desired allocations and investing those proceeds into asset classes that are underweighted. This process can help you keep your portfolio on track and achieve your goals.
Rebalanced portfolios tend to have lower risk and volatility than those that are left unattended. This can be a significant advantage for long-term investors who may not want to be exposed to market fluctuations. Additionally, rebalancing can help you avoid overpaying for assets when they are at their peak.
However, the benefits of rebalancing are dependent on the type of market conditions. For example, rebalancing is likely to be more beneficial in markets with weak correlations between the assets being purchased and sold. Additionally, rebalancing is unlikely to be effective in markets with high transaction costs. For these reasons, it is important to consider the potential impacts of rebalancing before deciding to implement it.