The basics of asset allocation
The
idea behind asset allocation is that because not all investments are alike, you
can balance risk and return in your portfolio by spreading your investment
dollars among different types of assets, such as stocks, bonds, and cash
alternatives. It doesn't guarantee a profit or ensure against a loss, of
course, but it can help you manage the level and type of risk you face.
Different
types of assets carry different levels of risk and potential for return, and
typically don't respond to market forces in the same way at the same time. For
instance, when the return of one asset type is declining, the return of another
may be growing (though there are no guarantees). If you diversify by owning a
variety of assets, a downturn in a single holding won't necessarily spell
disaster for your entire portfolio.
Using
asset allocation, you identify the asset classes that are appropriate for you
and decide the percentage of your investment dollars that should be allocated
to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to
cash alternatives).
The three major classes of assets
Here's
a look at the three major classes of assets you'll generally be considering
when you use asset allocation.
Stocks:
Although past performance is no guarantee of future results, stocks have
historically provided a higher average annual rate of return than other
investments, including bonds and cash alternatives. However, stocks are
generally more volatile than bonds or cash alternatives. Investing in stocks
may be appropriate if your investment goals are long-term.
Bonds:
Historically less volatile than stocks, bonds do not provide as much
opportunity for growth as stocks do. They are sensitive to interest rate
changes; when interest rates rise, bond values tend to fall, and when interest
rates fall, bond values tend to rise. Because bonds offer fixed interest
payments at regular intervals, they may be appropriate if you want regular
income from your investments.
Cash
alternatives: Cash alternatives (or short-term instruments) offer a lower
potential for growth than other types of assets but are the least volatile.
They are subject to inflation risk, the chance that returns won't outpace
rising prices. They provide easier access to funds than longer-term
investments, and may be appropriate for investment goals that are short-term.
Not
only can you diversify across asset classes by purchasing stocks, bonds, and
cash alternatives, you can also diversify within a single asset class. For
example, when investing in stocks, you can choose to invest in large companies
that tend to be less risky than small companies. Or, you could choose to divide
your investment dollars according to investment style, investing for growth or
for value. Though the investment possibilities are limitless, your objective is
always the same: to diversify by choosing complementary investments that balance
risk and reward within your portfolio.
Decide how to divide your assets
Your
objective in using asset allocation is to construct a portfolio that can
provide you with the return on your investment you want without exposing you to
more risk than you feel comfortable with. How long you have to invest is
important, too, because the longer you have to invest, the more time you have
to ride out market ups and downs.
When
you're trying to construct a portfolio, you can use worksheets or interactive
tools that help identify your investment objectives, your risk tolerance level,
and your investment time horizon. These tools may also suggest model or sample
allocations that strike a balance between risk and return, based on the
information you provide.
For
instance, if your investment goal is to save for your retirement over the next
20 years and you can tolerate a relatively high degree of market volatility, a
model allocation might suggest that you put a large percentage of your
investment dollars in stocks, and allocate a smaller percentage to bonds and
cash alternatives. Of course, models are intended to serve only as general
guides; determining the right allocation for your individual circumstances may
require more sophisticated analysis.
Build your portfolio
The
next step is to choose specific investments for your portfolio that match your
asset allocation strategy. Investors who are investing through a workplace
retirement savings plan typically invest through mutual funds; a diversified
portfolio of individual securities is easier to assemble in a separate account.
Mutual
funds offer instant diversification within an asset class, and in many cases,
the benefits of professional money management. Investments in each fund are
chosen according to a specific objective, making it easier to identify a fund
or a group of funds that meet your needs. For instance, some of the common
terms you'll see used to describe fund objectives are capital preservation,
income (or current income), income and growth (or balanced), growth, and
aggressive growth. As with any investment in a mutual fund, you should consider
your time frame, risk tolerance, and investing objectives.
Note:Before
investing in a mutual fund, carefully consider its investment objectives,
risks, fees, and expenses, which can be found in the prospectus available from
the fund. Read the prospectus carefully before investing.
Pay attention to your portfolio
Once
you've chosen your initial allocation, revisit your portfolio at least once a
year (or more often if markets are experiencing greater short-term
fluctuations). One reason to do this is to rebalance your portfolio. Because of
market fluctuations, your portfolio may no longer reflect the initial
allocation balance you chose. For instance, if the stock market has been
performing well, eventually you'll end up with a higher percentage of your
investment dollars in stocks than you initially intended. To rebalance, you may
want to shift funds from one asset class to another.
In
some cases you may want to rethink your entire allocation strategy. If you're
no longer comfortable with the same level of risk, your financial goals have
changed, or you're getting close to the time when you'll need the money, you
may need to change your asset mix.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The tax information provided is not intended to be a substitute for specific individualized tax planning advice. We suggest that you consult with a qualified tax advisor.
Securities offered through LPL Financial, Member FINRA/SIPC
The tax information provided is not intended to be a substitute for specific individualized tax planning advice. We suggest that you consult with a qualified tax advisor.
Securities offered through LPL Financial, Member FINRA/SIPC
