When it comes to investing, many people recommend that you diversify your accounts. The idea is to not put all your eggs in one basket.
Diversification will help the performance of your portfolio since everything is riding on one investment vehicle.
The problem with this is, how do you choose? You have hundreds of stocks, bonds, mutual funds and more to choose from when you are building your portfolio.
Some people try to diversify by simply buying a large number of different stocks, but this is not the best method.
Instead of simply buying stocks, you as an investor should purchase a mix of stocks, bonds, and mutual funds. This type of investment strategy is called asset allocation.
Asset Allocation Defined and Why it is Important
Anytime you invest money, you are taking a risk. The more risks you are willing to take, the more money you can make. However, the more risks you take, the more you stand to lose. Some asset classes are more prone to risk, and they have the highest returns when they are successful.
Other asset classes give less in returns, but they are considered to be the safer options. With asset allocation you want to balance the risk and return ratio by diversification.
This investments strategy involves dividing the money you invest into different categories, such as stocks, bonds, cash, real estate, and derivatives.
The different asset classes have different levels of returns and risk, and as a result, each one will behave differently over time. Different classes will do different things at the same time.
For example, local real estate may be booming, but the stock market may be falling.
When allocating your assets is important to know that while one type of investment class may be experiencing problems, your assets from other classes will still pull your portfolio up overall.
Some people do not think that this method of investing is effective; however, most investors generally agree that it is best protection against major loss.
Listed below are the different types of asset classes that each investor should have in order to make their portfolios diversified.
Common Investment Choices
1. Stocks – Out of all of the asset classes, stocks are the ones that offer the highest returns. However, stocks are the most volatile asset class making it one of the riskiest investment vehicles available.
Since January 13, 2011, there are currently nearly 3000 listings in the NASDAQ. Each stock option will have different returns, and the returns will depend on what the investor decides to choose. The stock market is a trade-off between risks and returns, the more risk that you are willing to take, the more rewards you can make.
In the long run, stocks tend to lead to returns, but you have to be ready to ride the ups and downs of the stock market. The average growth of stocks is around 10-12%, but you have to remember that each stock is different. .
2. Bonds – Many people think that bonds are less risky than stocks. Most importantly, bonds give a return no matter what. They promise to return the value of the bond when it is bought when it reaches maturity.
Stocks do not offer such a promise. Bonds pay out a fixed rate of interest, but stocks only offer dividends when the company declares it. Additionally, the bonds market is less vulnerable when it comes to price swings than the stock market is.
Bonds are less risky, but they offer less returns. Bonds are often issued by the government, such as the U.S. Treasury, but they can also be issued by corporations and state governments.
Some bonds offer higher returns that are similar to stocks, but these bonds are also known as junk bonds because they carry such a high risk. It is not advisable to invest in these types of bonds.
You might want to include more bonds in your portfolio, especially if you do not have much time to wait out the stock market swings. Bonds are a wise investment for people, who are nearing retirement or who will need cash in the near future.
3. Cash – Cash does not mean stuffing bills into your mattress. Instead cash investments include savings accounts, CODs or certificates of deposits, money market funds and deposit accounts, and treasury bills.
This type of investment is the safest type, and it carries the least risk and generally the lowest returns. All bank accounts like these are usually insured by the FDIC for amounts up to $250,000.
The concern with this type of investment is inflation. If inflation is rising faster than your interest rates are building your accounts, you are “losing” money because the value of your money is decreasing.
Depending on the economy, the interest rates that you can expect for these types of investment range from less than 1% to about 3% or 4%, depending on the length of the term.
4. Real Estate – Many people do not bother to add real estate to their portfolio at least beyond in terms of investment. We all invest when we buy a home, but the primary purpose of that real estate purchase is to not to make money but to have somewhere to live.
Real estate is an interesting investment option because it is generally stable, and it often has high returns. However, since about 2008 the housing market has encountered losses. I
n some areas, it is starting to show recovery, but it has yet to show consistent recovery or enough consistency to give investors confidence.
In a study that was conducted by a finance and economics professor at Baruch College in New York City, the annual returns of real estate market from 1978 to 2004 averaged 8.6%. Stocks, however, showed a better long term performance rate of 13.4%.
Other types of assets exists, such as precious metals, and you might want to consider including these types of assets in their portfolio. Gold has been becoming more popular lately because the stock market has been so volatile.
The reason that asset allocation is so important is that the four main types of asset classes have never all gone up or down at the same time.
One last thing to consider is the amount of time you have to invest. If you are young, you can often take more risks in terms of your investments. In the end, however, it a personal choice when it comes to what you invest in and for how long.
Call to Action
What does your current asset allocation look like?