What do the strongest investment portfolios have in common? They are composed of different asset classes (stocks, bonds, cash, property, commodities). This division of investment is called asset allocation and will help you spread risk and achieve your personal investment goals (education fund, retirement savings etc.).
Let’s examine what you need to know about asset allocation.
You’re investing your money to meet your financial goals, be it for a house, your child’s secondary education or any other savings plan. The goal you want to reach has a time horizon – perhaps a few years for the deposit on a house, or decades in the case of your retirement. This period of time and your tolerance to risk will determine your asset allocation. Higher risk investments are more suitable to long-term goals as they are able to ride out market fluctuations.
As you know, investing always brings risk – the more risk, the higher the potential pay-off. If you are very risk-averse and cannot contemplate loss of your investment, invest only in more secure options; you will not receive as high a return, but it should still outperform the interest rate offered by banks. A conservative, low risk, low return investor is said to be keeping a bird in the hand. An aggressive, high risk, high return investor is said to be seeking two in the bush. Good asset allocation aims to find a balance between these two.
A well-balanced investment portfolio spreads risk over a wide range of instruments – from less volatile property and bonds to riskier stocks and currencies. This is important because positive market changes in one class can cause other classes to slow or even drop. Different markets react differently to economic, political, social and environmental factors, so it’s wise not to put all your eggs in one stocklist.
Diversification is a two-level strategy: between asset classes, such as property, bonds or stocks, and within asset classes. However, 10 stocks in Apple (AAPL), $10,000 in Swiss francs (CHF) and a few ounces in gold is not a fully diversified investment portfolio. You also need to diversify your holdings within those asset classes and hold, in the case of a stock portfolio, a variety of stocks – from risky to less risky, in different currencies, in different industries – to reduce your risk exposure. This can be tricky and takes time to understand.
As your time horizon changes with age, you’ll probably want to change your asset allocation. As your investment goal approaches, a switch to safer assets may be the best policy. You may also want to rebalance your portfolio: this can seem hard, but the buy-low, sell-high-principle will help you to maintain that balance.
Selling high-performing assets will allow you to secure funding for re-investment in lower priced, perhaps even beaten down, assets with the potential for growth.
Good investors know how to spread risk and get the most from their money. Asset allocation and diversification according to your time horizon and risk tolerance will ensure that even if a market turns, not all your investments are lost. Vigilant investors will also change and rebalance their portfolios to ensure they buy low and sell high.
Before building your diversified portfolio, speak to your financial planner.