If you are like most people, you’ve likely had experience with both diversification and asset allocation. The crazy part is you may have never realized it.
Think about your favorite breakfast spot. You typically have many options, so where do you start? As “N” always asks me, do you want something sweet, or do you want something savory?” Could you imagine a place with only eggs or only pancakes?
Once you decide whether you want sweet or savory, you next decide how you want it. Do you want your eggs scrambled or over easy. How about in an omelet, or my favorite, a burrito. Your options are nearly unlimited. Wasn’t that smart of the breakfast place to offer you a lot of diversity!
Investing is no different; you want to be sure you have sweet AND savory, and you want to be sure you have different options for filling both needs.
What is Asset Allocation?
Asset allocation is the sweet and the savory. You need to decide what percentage of your money you want divided into various buckets, mainly stocks, bonds, and cash.
How you decide to allocate your money into these different options should be defined by your risk tolerance, time horizon, income, expectations, and various other factors.
Generally speaking, if you are a risky investor you will have more of your money invested in stocks. History shows us that stocks have a greater likelihood of earning money over the long run. Stocks also have a greater chance of losing money.
If you are a conservative investor, you will likely be more comfortable with bonds or cash. Bonds and cash historically earn less. So why would you ever choose to earn less? Primarily because you aren’t comfortable with the inherent ups and downs of stocks.
There is good news for bonds too. The good news is bonds typically have less volatility (aka, they are unexciting). The ups aren’t as high, but the lows aren’t as low.
Keep in mind all bonds are not created equal. Depending on the type of bond you purchase, you may be exposed to credit risk, prepayment risk, default risk, and interest rate risk.
What Should My Asset Allocation Be?
This is the million dollar question! The decision on how you allocate your assets is a critical one (probably more important than whether you want your eggs scrambled or over easy).
Your initial asset allocation will be dictated by a number of considerations. The goal is to balance your return expectations (how much you want to make) with your appetite for risk (how much are you willing to lose).
The low risk, high return mythical unicorn we all seek doesn’t exist. If you think you’ve found it, I am assuming your friend Big Foot told you about it while visiting the leprechaun at the end of the rainbow. Sarcasm my friends, sarcasm.
Keep in mind your allocation can change as your financial situation changes. Some things to consider are the following:
- If and when you need the money
- What type of money is it (IRA, ROTH IRA, 401k, taxable, etc.)
- Do you have other assets in addition to these assets
- Your age
What is Diversification?
Diversification is how your want your eggs cooked, or whether you want pancakes or french toast.
It is simple really. Don’t put all your eggs (sweet pun!) in one basket.
Assuming you have already decided on an appropriate allocation as discussed above (you’re such a good learner), the next step is to pick investments to help fill your need. The goal should be to invest in a number of similar but different strategies.
Diversification encompasses all the options on the breakfast menu. When looking at stocks, you can diversify into large, medium, or small cap stocks (or stock funds). You can choose growth or value stocks. You can decide if including international stocks makes sense for your portfolio. You can even look into emerging market stocks and weigh the potential versus risk for your comfort zone.
Bonds have all different types too. You can be invested in short term or long term bonds (or bond funds). You can include corporate, municipal, or government bonds, bonds with high quality, or high yield.
A good diversification strategy should allow your money to be invested in stocks and bonds with multiple objectives and expectations.
Asset allocation or diversification does not guarantee a profit or protect against loss.
Past performance is no guarantee of future results.
Small cap stocks may be subject to a higher degree of risk than larger, more established companies’ securities, including higher risk of failure and higher volatility. The illiquidity of the small-cap market may adversely affect the value of these investments so those shares, when redeemed, may be worth more or less than their original cost. The Standard & Poor’s Midcap 400 is a capitalization weighted index that measures the performance of the mid-range sector of the U.S. stock market. Investors cannot invest directly in an index.
Mid-cap stocks may involve additional risks due to their greater volatility and lower liquidity than larger companies.
Large cap stocks typically have at least $5 billion in outstanding market value.
Corporate bonds are debt securities issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company’s physical assets may be used as collateral for bonds.
Corporate bonds are considered higher risk than government bonds. As a result, interest rates are almost always higher.
Municipal bonds are debt securities issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if the investor lives in the state in which the bond is issued.
Government bonds are guaranteed by the U.S. Government and if held to maturity, offer a fixed rate of return and fixed principal amount. Guarantee only applies to the timely payment of principal and interest and does not pertain to the portfolio, mutual fund, or variable annuity holding such securities. Values will fluctuate, and upon redemption, share values may be worth more or less than the original investment.