Spreading Your Risk Through Asset Allocation
Diversification is often the key to financial success
Let’s say in the late 1990s you were a self-proclaimed tech nerd. Your work was in tech. You built a career in tech. You knew good technology when you saw it. You were plugged into the tech community, and you were a true believer in the future of tech. When it came time to invest your savings, where did you put your money? In tech, of course.
A lot of people did the same thing and got very rich on paper. But a gong went off somewhere at the end of 2000 signaling a peak for the tech market, known as the dot.com or tech bubble back then. The value of those stocks fell so fast many people couldn’t believe it was happening. So they watched it drop and watched their savings go with it.
There have been speculative bubbles in the investment world since the Dutch began selling tulips. But when those bubbles burst it was investors who had all their money in those assets who suffered the most. People who applied something called asset allocation to their portfolios usually fared much better.
Spread the Wealth
Asset allocation is about spreading an investment portfolio among different asset categories, such as stocks, bonds, and cash. It is a basic method to guard against the risk of losing your money, which is inherent in investing. For socially responsible investors, one could also consider a distribution of assets between stocks and community investing as a form of asset allocation.
How you allocate your assets among categories depends on where you are in your life. You need to ask two questions: what is my time horizon for my investments and how much risk can I tolerate.
Is there a particular financial goal towards which you are saving? Retirement? College tuition? Buying a home? Then the number of months or years that you are away from that expense is your investing time horizon. The longer you have before reaching that point, the greater your ability to assume more risk and the larger your reward potential. A long time horizon allows an investor to weather the ups and downs of the business cycle and the markets. A person in their 20s saving for retirement has 40 years to build a nest egg.
A parent starting a college fund for a 10-year-old child has only eight or nine years.
Aggressive investors are people who can live with the greater possibility of losing money in exchange for the potential of higher results. That person would put more of their money in growth stocks, for example, rather than a low-interest paying treasury bill. A conservative investor is someone with a low tolerance for risk who favors investments that provide guaranteed income, such as bonds over price appreciation. Retirees, who are out of the workplace and rely on their investments for income, typically have a large percentage of bonds or other income generating investments in their portfolios.
Historically the three major classes of assets – stocks, bonds, and cash – have not moved together during market gyrations. Whatever is occurring in the economy that causes one to do well often has an adverse impact on another. By including all three in a portfolio, you can offset any serious declines that might occur in a class. The way to make money through asset allocation is to determine your time horizon, understand your tolerance for risk and then distribute your funds among aggressive or conservative assets.
The longer the time horizon, the more aggressive a portfolio should be.