Asset allocation: a term heard frequently in the retirement savings world. It’s touted as one of the most important components of developing a healthy long-term investment portfolio, but let’s be honest, the average saver most likely doesn’t know what it means or how it can help them. Saving early, compound interest, and taking advantage of a company match are all important components of saving for retirement, but asset allocation holds a valuable place too.
What does “Asset Allocation” mean?
The technical definition is: “an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon”. So, all clear on that now, right?
Just in case you still have some questions, let’s break it down. At the most basic level, asset allocation simply refers to the way your money is divided across different investments, such as stocks, bonds, real estate, and other subcategories like large, mid-sized, or small companies. The term also refers to the strategy behind this aspect of investing as well. Diversifying your portfolio by investing in a mixture of varying asset classes allows an investor to reduce their risk in the markets.
In other words, keeping all of your money in one asset class is considered extremely risky. Fluctuations in every corner of the financial markets are inevitable, but that doesn’t mean keeping your investments in one place is the best way to go. Think back to 2008 when the stock market dove 37 percent. If all of your money had been invested in the market and depending on when you would have needed to use your savings, you would have had quite the problem on your hands. Riskier assets, such as stocks have a higher expected rate of return though, so it’s important to not avoid these types of investments completely and miss out on potentially greater returns.
A simple way to think of asset allocation is to think about preparing a balanced meal for yourself. We’re supposed to have a mix of protein, carbohydrates, fruits/vegetables, etc., but sometimes that doesn’t seem very appealing, and we only really want one thing. (Most likely that one thing is pizza, right?). Sure, we’ve all had those nights where eating a heavily carb-laden meal seems like the most satisfying (and delicious) answer, but if you do that every day, you’re not gonna feel too hot. Your investment portfolio works the same way. You have to have a healthy dose of all kinds of stocks and bonds to get the most nutritional value out of your portfolio in the future.
So, what can Asset Allocation do for you?
As briefly discussed earlier, there are a number of factors that go into making your retirement savings strategy a success, and asset allocation is most definitely one of them. Here are the main reasons why:
- Fees: Mixing up your allocation among passive and actively managed accounts means that you can mitigate fee costs to some degree. Fees are an inevitable cost of investing and a serious consideration.
- Beating the stock market: This isn’t a thing that anyone can do, let alone an average person saving into a 401(k) or similar long-term savings vehicle. Finding the correct asset allocation for your age and risk tolerance will ensure that you don’t need to obsessively watch the markets to buy low and sell high. Asset allocation can take away that guesswork.
- Risk: While asset allocation does not protect you from all risk, it certainly can lessen it. By branching out and opting to invest in a variety of funds across a broad range of asset classes, you’re mitigating the volatility your investments are undoubtedly subject to in one quick move. Say international markets take a hit. If you’re well-allocated, then the personal hit you take from that is significantly lessened by diversifying your portfolio.
Furthermore, research demonstrates that asset allocation will be responsible for more than 90 percent of portfolio returns, making it far more important than specific fund selection.
Figuring out your optimal allocation
There is no one-size-fits-all formula in terms of what asset allocation strategy will be right for you. Your age, current savings, time until retirement, and risk tolerance are all considerations that will affect your diversification needs. While we would always recommend discussing these decisions with a financial professional if possible, there are some general guidelines you can follow. For instance, the younger you are the more risk you can take, so investing a larger percentage in stocks is usually better. As you get closer to retirement, you have less time to weather market downturns, and allocating more of your money to conservative investments is advisable. Here’s a simple rule of thumb to help you get started:
One thing everyone can do though is re-balance their portfolios every few years. Rebalancing involves resetting the percentages invested in each asset class back to their original percentages. According to J.D. Roth at Get Rich Slowly, “there are a couple of reasons to rebalance. First, by selling asset classes that have risen in value, and by buying other asset classes that have dropped, you are selling high and buying low. Second, if you don’t rebalance, it’s possible for your asset allocation (and investment risk) to become radically different from your intended levels”.
The main takeaway from this is that finding the right asset allocation can ensure that your mix of investments, tailored to your specific risk tolerance, will help you reach your goals, no matter what they are.
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investment decisions
Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved
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