Retirement Savings: 6 Tips To Know About Asset Allocation To Achieve Your Investment Goals
Written by
John Csiszar
Edited by
Amber Barkley
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Asset allocation refers to putting money into different investments with different characteristics. The idea is that this type of diversification can reduce the risk in your portfolio, as “putting all your eggs into one basket” exposes you to significant potential losses.
But asset allocation doesn’t mean you should randomly spread your money across whatever investments you can find. A good asset allocation follows a strategy and is tailored to your specific investment objectives and risk tolerance. When it comes to diversifying your investment account, here are some of the most important tips to remember.
Diversify Within Asset Classes as Well
Most investors understand that they should diversify among different types of investments, such as stocks and bonds. However, it’s equally important to diversify within asset classes. In other words, for most investors, your asset allocation shouldn’t just be large-cap stocks and AAA-rated domestic bonds. Although each investor is different, you’ll likely want to add some small- and mid-cap stocks to your portfolio, both growth and value, along with international stocks and bonds.
This offers true diversification. If you own 20 different stocks but they are all large-cap growth stocks, they’re all likely to move more or less in tandem, eliminating your diversification benefits.
Aim To Maximize Reward vs. Risk
A good asset allocation isn’t just a collection of random investments. Rather, it considers each component in terms of how it affects the entire portfolio’s risk-reward ratio. A financial advisor with advanced tools can provide a mathematical analysis of your portfolio, but you can do your own legwork to balance out your more aggressive investments with safer options.
For example, if you have aggressive, speculative stocks, you can balance out your risk with some more conservative options, like blue-chip stocks. Bonds, commodities like gold or any other asset that doesn’t move in the same direction at the same time as stocks can reduce the volatility of your overall portfolio.
Vary Your Allocation as You Age
Your asset allocation shouldn’t be static and unchanging. As you age, your risk tolerance and financial needs generally change as well, and you’ll need to modify your asset allocation to reflect this.
For example, as you approach retirement, most advisors will suggest that you lower your risk profile, because you won’t have as much time to recover. If you’re about to retire and your portfolio suddenly drops 30%, for example, this could devastate your retirement lifestyle or even require you to work for additional years. When you’re in your 20s, on the other hand, you have decades to recover from any downdrafts in your portfolio value, so you can afford to be a bit more aggressive.
Tailor Your Allocation to Your Personal Financial Situation
There is no “standard” asset allocation that works for all investors. Your income, lifestyle, risk tolerance, age, net worth and other factors can all affect how you should set up your portfolio. While the general principles of asset allocation apply to everyone, the specifics of your particular portfolio should be tailored to your individual financial situation.
This is why it’s a good idea to speak with a financial advisor who has experience in taking a holistic approach to creating a portfolio.
Avoid Overdiversification
One of the risks of asset allocation is overdiversification. When slicing up your portfolio into individual components, it’s easy to get carried away and diversify too much. After a certain point, owning too many stocks becomes a detriment to your portfolio rather than an enhancement.
If you own 100 large-cap stocks, for example, your return is likely to correlate very closely with the S&P 500 large-cap stock index. At that point, you might as well just buy the S&P index itself rather than having to analyze and monitor 100 individual positions.
Often dubbed “diworsification,” owning too many investments tends to increase your costs, consume more of your time and lower your overall risk-reward profile.
Don’t React To Short-Term Market Events
Once you’ve developed the optimal asset allocation for your needs, it’s important to stick with your plan. A well-conceived asset allocation is a long-term plan designed to serve you for years and years, through varying market cycles. If the stock market drops 20%, for example, it’s imperative that you avoid the temptation to alter your asset allocation and pull out of stocks completely.
Historically, the market has always recovered from its bear periods and gone on to make new highs, so if you pull out when it is down, you’re likely to miss a big recovery. This will wreak havoc on the long-term returns of your portfolio. The same is true for every component of your asset allocation, such as bonds or international investments, each of which is likely to go through its own bear market over time.
Stick to your asset allocation, rebalance when necessary, but avoid overreacting to short-term market events.
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