CONTRARY TO WHAT YOU might see in television shows or newsletters, your investments should not be a collection of stock picks, thrown together randomly because someone said it a particular security was “hot” or had good potential.
Before jumping in to pick investments for your account, be sure you understand your objective. An investment account has a different purpose than a trading account. The former is allocated to meet a particular objective, while the latter is essentially fun money.
Are you saving for retirement? What is your time horizon? How much money do you need to retire comfortably? How comfortable are you with market volatility? Do you tend to panic, or are you calm while you wait out a downturn?
What Do You Need?
When you have the answers to these questions, then you can begin the process of selecting your investments. If you try to reverse that order, you’ll wind up with a bunch of “stuff” that has little chance of contributing to your actual goals. In fact, the wrong assortment of securities could do more harm than good.
It’s fairly easy to understand the benefits of diversification, but how should you put that into practice?
Say your goal is retirement. You expect to work for another 10 years, and then be retired for 25 years after that. With today’s life expectancies, that would not be an unusual scenario.
Your dilemma is: How can you be sure you don’t outlive your money, and have enough to cover your expenses when you no longer have a paycheck from a job?
That’s where asset allocation comes into play and the first step is reviewing the broad asset classes available to you.
In their most basic terms, asset classes are cash, stocks and bonds. There are others, including real estate, commodities or collectibles, but when you are beginning to select investments, start with the essentials.
The main point to consider is: What risk level do you take to generate the return you need? This is a calculation that a financial planner should do for you, as it’s difficult for an individual to unemotionally and accurately develop his or her own financial plan. There are too many variables and it’s important to remove personal bias.
The Right Mix
Cash should be one element of your allocation. This is to allow liquidity, but it does not keep pace with inflation. For many people, cash feels safe and secure, but it carries its own risks. Because inflation grows faster than interest rates on bank or money market accounts, your spending power is eroded if you keep too large an allocation in cash.
The next asset class, stocks, have been, over time, a proven way to beat inflation. If held in traditional brokerage accounts, including retirement accounts, they are easy to liquidate if you need cash quickly.
As most investors know, stocks are prone to wide price variations. Stocks get the lion’s share of media attention, partly because stock trading has been portrayed as an exciting endeavor, similar to gambling.
Stock movements also stir up investor emotions. When stocks go into a sharp downturn, many people believe selling is the best way to protect themselves. However, selling when stocks head south is generally a terrible move. You lock in losses, which means your account needs to show even stronger gains to get back to even. Rather than offering protection, the stock sale resulted in a decline that could have long-term effects. That could hurt your chances of achieving your investing goals.
Fixed-income refers to bonds. This is debt issued by a government or corporation. Bonds offer growth of your principal. They return more than cash, but less than stocks. When investing in fixed income, be cautious about the securities you select. High-yield bonds may sound more desirable, but this it is risky debt that the issuer may not be able to pay.
Better to invest in bonds that ratings agencies deem to be investment grade. This means the issuer is more likely to satisfy the debt. This higher degree of certainty means there is less risk, which in turn means a lower payout. However, bonds serve a purpose in dampening the volatility of stocks.
Think of broad asset classes as your building blocks. Once you understand what return you need to generate, you can select the right mix of cash, stocks and bonds. As always, consult a planner to help you determine what is best for your unique situation.