You invest in making your money grow, but your chance of loss is much higher than anything else without asset allocation and diversification.
Fortunately, learning the basics of asset allocation and diversification is not as hard as it sounds. Check out this beginner's guide to the investment strategies you should implement today.
What Is Asset Allocation?
Asset allocation is the way you divide your investments between different asset classes within your portfolio to help you reduce risk and possibly increase returns over time.
Chances are, you will invest in the most common asset classes such as stocks, bonds, and cash investments. It is important to remember that many other investment options are available to you. Investing in alternative options such as real estate, farmland, and commodities will help you diversify your portfolio and mitigate risk.
When making your asset allocation plan, there are several asset categories to choose from. Here are a few investment options to consider when making the best choice for your financial goals.
Stocks are a type of security that gives the company's investor part ownership and a share in that company's earnings. With stocks, anyone can invest in some of the most successful companies around the globe.
Bonds are like an IOU. The investor who buys the bond is loaning money to the issuer for a fixed amount of time. At the end of that period, the bond is paid back to the investor. Interest is typically paid twice a year.
Cash investment is a short-term obligation, usually about 90 days. Investors can expect a return in the form of interest payments. They are shallow risk and are usually insured by the FDIC.
Alternative Investment Options
Any investment that falls outside of stocks, bonds, and cash would be considered an alternative investment. This would include tangible assets such as art, wine, antiques, coins, stamps, and financial assets like real estate, venture capital, hedge funds, commodities, and farmland.
Many people fail to consider alternative investments when creating their asset allocation plan, which is a huge missed opportunity. Take farmland, for example. When you invest in farmland, the risk is relatively low, and it is resilient to inflation in times of market turmoil.
Farmland returns have been positive every year since 1990, yet several investors do not know this is an option for their portfolios. Investing in farmland is easier than ever with companies like FarmTogether. FarmTogether provides an all-in-one investment platform that helps you grow your wealth and diversify your platform with investment minimums as low as $10,000.
Think of asset allocation as spreading your investments across various asset categories. You spread out the risk by investing in some or all asset categories since they typically work inversely (when one does well, another may decrease and vice versa). It is important to do your research to build the best asset allocation for your portfolio.
Choosing the Best Asset Allocation
Wise investors will build a portfolio based on factors that include risk tolerance, time horizon, and overall financial goals.
Asset Allocation Based on Risk Tolerance
Risk tolerance is the degree of loss an investor can handle while making investment decisions. Investors usually fall into three main categories: aggressive, moderate, and conservative. For example, if you have a low-risk tolerance, your portfolio will consist of mostly conservative, low-risk investments. If you have a high-risk tolerance, you are willing to take the risk of losing ‘everything' in exchange for higher rewards.
A higher risk tolerance leaves room for heavier investments in aggressive assets, such as stocks, and a lower risk tolerance calls for more conservative investments, such as bonds.
No matter what category you fall within, you will still have a mix of different asset classes within your portfolio. It is the percentage of funds you allocate to each class that will change.
Asset Allocation Based on Age
Your age and risk tolerance will have a large impact on your asset allocation decision. Many investors will use the common asset allocation rule called The 100 Rule when making investment decisions.
The rule states that you should take the number 100 and subtract your age. The answer should be the percentage of your portfolio that you invest in stocks.
If you're 35, this rule suggests you should devote 65% of your money to stocks. The rest would be spread out between different asset classes. The rationale behind this rule is that younger investors will have longer time horizons to weather the volatile stock market's storms.
If you are nearing retirement, you will need your money sooner. There are some risks in all investments. However, those close to retirement may want to focus more on low-risk investments such as high-grade bonds, money market funds, and certificates of deposits.
Asset Allocation Based on Goals
Some asset allocation plans are built with a specific goal in mind, like saving for the purchase of a car, house, or college tuition. Your goals are taken into consideration when building your risk profile and time horizon. This means that someone nearing retirement may have a portfolio with higher risk investments if they put money aside for a new grandchild's college tuition. Some critics are concerned that some investors may be taking on more risk than necessary with this asset allocation plan.
Still, every investor is different and has varying levels of risk tolerance.
Why Asset Allocation Is Important
Asset allocation helps investors lower risk through diversification. Historically, each of the asset categories has worked inverse of one another. When one does poorly, the others do well. Allocating your assets according to your risk tolerance and financial goals helps you make sound investment choices based on research rather than emotion.
What Is Diversification?
The diversification definition is the technique of spreading your investments around, so your exposure to risk in one particular asset category is limited. This practice was designed to help investors lower the volatility of their portfolios over time.
How to Diversify
There are numerous ways to diversify, but a good rule of thumb is to invest in various industries and/or companies. For example, if you are interested in investing in technology, do not put all your money into one technology company. Instead, allocate a portion of your funds to a few technology companies, and the remaining funds should be invested in other industries not related to technology.
If you like a specific industry and feel strongly about investing a large portion of your portfolio in it, make sure you diversify your remaining funds as much as you can. The goal is to reduce risk. If that one industry were to become very volatile and tank in the market, so goes your portfolio with it if it is not well diversified.
This is why it is essential to include investment options like farmland in your portfolio because of their positive historical returns. Per FarmTogether, the average annual return for farmland from 1970-2015 has been 10.5%. When you have investments that you can depend on even during market downturns, it may be possible to take on more high-risk, high-reward investments in other areas of your portfolio.
Why Is Diversification Important?
Diversification is important because you can maximize your returns by investing in different areas that would react differently in the same volatile market.
For example, if you only carry a spare tire in your vehicle, that will not be of much use if your battery dies. That does not mean you get rid of the spare tire and go purchase jumper cables. To lower the risk, you would carry both items and any other item that would help you if anything were to happen to your vehicle.
This is the same with investments. Since there will always be a risk for investing, diversification is one of the best ways you can mitigate that risk while maximizing your returns.
Can Diversification Reduce All Risk?
No diversification strategy eliminates all risk, but diversification can reduce unsystematic risk or risk specific to one company. This risk is an isolated event that happens to a particular company that is not likely to happen to other companies, such as a natural disaster. If one company burns down, it is improbable that every company in your portfolio will too. Diversifying among different companies eliminates or reduces unsystematic risk.
Diversification cannot eliminate systematic risk, though. Nationwide or worldwide events, such as war or inflation, are systematic risks because they could affect any or all companies within your portfolio no matter how much you diversify. This risk affects the market as a whole. Remember, the diversified portfolio definition aims to reduce risk; however, it does not eliminate it.
When researching the best ways to diversify your portfolio, consider different factors that could affect your portfolio, reaching your financial goals, such as choosing between related diversification and unrelated diversification. Review the risks and potential returns to ensure they align with your financial plan.
What Is a Well-Diversified Portfolio?
Every investors' goal should be to minimize risk while maximizing performance. To create a well-diversified portfolio, you must invest in various industries and assets. In other words, you do not put all your money into one category.
Even if you were to invest in all stocks (which you should not), a diversified portfolio would invest in companies across all industries. This way, if one industry, say farming, fell hard, while another industry, such as technology, did well, you'd offset your farming losses with your technology wins.
What Is Rebalancing?
Rebalancing investments is bringing your portfolio that has deviated away from your target asset allocation back into line. This deviation can occur due to adding or removing funds from your account or due to natural market fluctuation.
Rebalancing offers investors the opportunity to sell high and buy low, taking gains from high-performing investments and reallocating them to securities or other investment options that have not yet experienced such growth.
How Rebalancing Works
Periodically, investors should review their portfolio asset allocations. Once you have determined your ideal asset allocation and ensured that it aligns with your financial goals, compare it against where your portfolio currently stands.
For example, if your ideal asset allocation is 50% stocks and 50% bonds and yet your portfolio has fluctuated to 63% stocks and 37% bonds, it would be time to make some adjustments.
Investors rebalance their investments by purchasing and selling portions of their portfolios to set each asset category's weight back to the ideal asset allocation.
Dangers of Imbalance
In the example above, the portfolio has a much higher stock percentage than what the investor has listed in their ideal asset allocation. The allocation could be based on the client's risk tolerance or perhaps a goal the investor has in mind. A higher percentage of stocks typically means a higher chance of risk. If the investor's stocks are currently invested in experiencing a sudden downturn, their portfolio will suffer a great loss.
There is no required schedule for rebalancing your portfolio. Due to fees that may be associated with buying and selling securities, you'll want to choose a schedule that won't be too costly or time-consuming. Some financial advisors recommend reviewing and possibly reallocating your portfolio every 6 to 12 months. Every investor is different, so do your research and/or talk to an investment advisor to create the best plan for your goals.
Protect Your Investments With the Right Strategy
Asset allocation and diversification can be an active strategy to varying degrees. As an investor, you have the choice to review your investments on your own, hire a financial advisor, or use an automated service such as a Robo advisor to ensure you have a well-balanced portfolio.
Investing is rarely a ‘set it and forget it' type of deal. Having an asset allocation plan that works best for you will greatly impact your financial goals. Whether financial or otherwise, any goal will require a level of intentionality that cannot be skipped. This includes building a diversification plan to maximize your returns while reducing risk.
Creating an asset allocation plan and diversifying your assets is wise to begin planning for your retirement or building wealth. The best asset allocation plan varies from person to person. Ensure you do your research and work towards a plan that will help you reach your personal financial goals.
Master the art of asset allocation and diversification to ensure your portfolios make your money work for you. When you diversify and allocate your assets, you give your money the best chance to grow.
Michael launched Wealth of Geeks to make personal finance fun. He has worked in personal finance for over 20 years, helping families reduce taxes, increase their income, and save for retirement. Michael is passionate about personal finance, side hustles, and all things geeky.