How to Understand Asset Allocation


asset allocation

asset allocationHow’s your asset allocation? Smart investors understand the need to spread investment dollars across a wide variety of asset categories. Dad called it “not putting all your eggs in one basket”. Financial planners call it asset allocation and a key component of a successful financial future involves a thorough understanding of asset allocation.

Asset Allocation and Diverse Investments

Asset allocation assumes a wide variety of investments to perform differently based on the conditions of the market and changing economic conditions. In short, diversification reduces risk.

While spreading assets out means that you’ll likely always have assets that will be performing less than average, overall performance of your portfolio will typically show gains.  While there are never any guarantees when it comes to investing, asset allocation and diversification of your investments reduces “single-security risk” and it’s a smart way to manage your retirement money.

A primary advantage of asset allocation is that it allows you to put your money in high-risk stocks while reducing the risk of losing money.  It’s a strategy that can pay off big if all of your high-risk investments see a gain over time.

The investments you choose are typically lumped into three asset classes:

1) Stocks – These carry the most risk with the greatest opportunity for reward.  What makes stock investment so appealing is that their gains have always surpassed the cost of inflation.  Your 3% yearly raise at work typically covers the cost of inflation (and no more), so you need some successful high-risk investments in your portfolio.

2) Money Market Instruments – Low risk investments, which means the lowest potential return.  No potential to outpace inflation but as close to a “safe bet” as you’ll come when investing.  Great investments when nearing retirement.

3) Bonds – Average risk with average potential return.  The price fluctuation is historically never as severe as stocks.  This can be a good thing or a bad thing, depending on which way they’re headed.

investment risk

A key component of asset allocation is changing your investment risk as you age. Younger persons are typically encouraged to engage in high-risk stocks and as retirement gets closer, reduce the risk by investing in bonds. The idea being that a young man can regain lost investments in a worst case scenario and if the high-risk investment works, he can create substantial early growth, which multiplies quickly with compound interest.

Are you closer to sixty than 30 years old? We all remember Enron and it’s a primary example of why investment risk should always be minimized with age.

Talk to your financial planner to decide on an investment plan that works best for you.   While it should be pointed out that past-performance of the stock market never guarantees the future, the historical data for asset allocation is promising.

If you know how to understand asset allocation and use it to your advantage, you “nearly” guarantee yourself a good retirement income.

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