Whether it’s saving money to buy a home or planning for your golden years, the safest and fastest route to your financial destination is dividing your money among several asset groups. As an investor, asset allocation is the most important decision you can make.
Independent studies have shown that a portfolio’s returns stem from the decision of the myriad investments that you target. Asset allocation helps investors ride out shifts in the economy as well as hedge against market swings.
The generic asset classes are cash (which includes your savings, checking, CD and money market accounts), stocks, bonds and, in some cases, real estate. “Cash is really used for your emergency fund,” says Benay Curtis-Bauer, a financial advisor at Morgan Stanley Dean Witter in San Francisco. “Depending on how many people are dependent on your income, you need to stash away at least three to six months’ worth of living expenses.”
Other assets offer more appreciation and, at times, more risk. Bonds are IOUs representing debt issued by a company, municipality or the federal government. The issuer promises to pay back the loan at a stated date, or maturity date, plus an annual fixed rate of interest. With stocks you’re seeking capital gains by buying a piece of a company. Although investors usually purchase the securities based on value-companies selling at bargain prices, or growth-companies whose sales or earnings per share are growing at an accelerated rate.
Asset allocation is an individual choice, which will vary according to your age and income. “There is a rule of 100, which says that the percentage of the equities in your portfolio should equal 100 minus your age,” says Eric McKissack of Ariel Capital Management, a Chicago-based investment management firm.
Following those guidelines, if you’re 40, you should have 60% invested in stocks (35% in value and 25% in growth), 20% in bonds and 20% in cash equivalents. A 60-year-old, on the other hand, should have 40% of his or her money invested in stocks, 40% in bonds and 20% in cash. The idea is that your portfolio should become more conservative as you get closer to retirement age.
Putting together an asset allocation plan is like buying a custom-made suit-it has to fit you. First, determine if you’re willing to lose money in any given period, whether it’s quarterly, semi-annually or annually. Fill out an investor’s profile to measure your risk tolerance and investment objectives (available from any financial planner and some investment Internet sites). For instance, someone who is single and under 30 will probably be a more aggressive investor than an individual who is over 40 and married with three children.
But be honest, though. If you state that you’re an aggressive investor and can stand to part with 20% of your portfolio, it means you’re willing to lose $2,000 on a $10,000 investment portfolio. If this causes you great distress, then adjust your profile.
Asset allocation is not a market-timing device but a tool for building long-term wealth. Every investor wants to get whopping returns but